NEW YORK UNIVERSITY FINANCIAL ECONOMICS II Spring 2003 Franklin allen and douglas gale January 24, 2003 Topic 1: What is Corporate Finance?(cont 1 2 Financing Decisions In the previous section the focus was on investment decisions. It was assumed throughout that the firm was financed with equity. In this section we discuss financing decisions. As a prelude to this we will briefly discuss the notion of efficient markets and some of it's implications for corporate financing decisions. After that we will briefly mention some of the securities that are issued Then we will consider the main financial decisions of the firm, capital structure and payout policy. We will apply these ideas to valuation. Finally we will discuss real options very briefly 2. 1 Efficient Markets and Corporate Finance We have argued that all shareholders should agree if a firm uses the net present value rule to make capital budgeting decisions. How does the stock market view such decisions? What is the relationship between a firm s stock market value and its use of the NPv rule? Efficient Markets Hypothesis A firm' s stock market value is determined by the discounted value of its cash flows
1 NEW YORK UNIVERSITY FINANCIAL ECONOMICS II Spring 2003 Franklin Allen and Douglas Gale January 24, 2003 Topic 1: What is Corporate Finance? (cont.) 2 Financing Decisions In the previous section the focus was on investment decisions. It was assumed throughout that the firm was financed with equity. In this section we discuss financing decisions. As a prelude to this we will briefly discuss the notion of efficient markets and some of it’s implications for corporate financing decisions. After that we will briefly mention some of the securities that are issued. Then we will consider the main financial decisions of the firm, capital structure and payout policy. We will apply these ideas to valuation. Finally we will discuss real options very briefly. 2.1 Efficient Markets and Corporate Finance We have argued that all shareholders should agree if a firm uses the net present value rule to make capital budgeting decisions. How does the stock market view such decisions? What is the relationship between a firm's stock market value and its use of the NPV rule? Efficient Markets Hypothesis: A firm's stock market value is determined by the discounted value of its cash flows
This is based on stock markets being competitive and having n many profit-seekins investors. The following example illustrates the basic idea Example Consider a firm which for simplicity only lasts for two periods and that has per share cash flows which are paid out to shareholders as follows 125 140 The opportunity cost of capital is 10 percent Discounted cash flow 2.29 1.11.12 What would happen if the stock was selling in the market at 2.00? How could investors make money? Suppose an investor borrowed 2.00 and bought one share. Since the discounted present value of the payments on the stock is 2.29 the investor will be able to pay back the loan and make a profit in term s of today's dollars of 0. 29. To see this another way Debt to buy share 2.00 2x1.1=2.2 0.95x1.1=1.045 (including interest) Less pay 1.25 End of period debt 0.95 0.355 In other words the investor is left with 0.355 at date 2 which is equivalent to 55/1.12=0.29 at date 0. Everybody will therefore try to borrow and buy shares. The price will be bid up to 2.29
2 This is based on stock markets being competitive and having many profit-seeking investors. The following example illustrates the basic idea. Example Consider a firm which for simplicity only lasts for two periods and that has per share cash flows which are paid out to shareholders as follows: C1 C2 1.25 1.40 The opportunity cost of capital is 10 percent. What would happen if the stock was selling in the market at 2.00? How could investors make money? Suppose an investor borrowed 2.00 and bought one share. Since the discounted present value of the payments on the stock is 2.29 the investor will be able to pay back the loan and make a profit in term's of today's dollars of 0.29. To see this another way t= 0 1 2 Debt to buy share 2.00 2x1.1 = 2.2 0.95x1.1 = 1.045 (including interest) Less payment - 1.25 - 1.40 End of period debt = 0.95 = - 0.355 In other words the investor is left with 0.355 at date 2 which is equivalent to 0.355/1.12 = 0.29 at date 0. Everybody will therefore try to borrow and buy shares. The price will be bid up to 2.29. = 2.29 1.1 1.40 + 1.1 1.25 Discounted cash flow = 2
Suppose the price was 2.35 what should somebody who owns the stock do? The owner should clearly sell since this gives 2. 35 whereas if the stock was held onto it would pay off 2.29 in terms of today's money. If everybody who owns the stock tries to sell the price will fall until it is equal to 2.29 Whenever prices get out of line with discounted cash flows there will be profit opportunities. The efficient markets hypothesis is essentially arguing these can't last for long. In other words arbitrage ensures that prices reflect discounted cash flows If stock market prices reflect discounted cash flows then this implies the following Implication of Efficient Markets Hypothesis la positive NPV project is accepted the value of the firm will increase by the amount of the project's NPk Hence accepting positive NPv projects leads to an increase in stock price and the creation of shareholder wealth. Rejecting negative NPV projects avoids a fall in share price and the destruction of shareholder wealth This fundamental view of the stock market is at the heart of most corporate finance theories. An alternative view is a technical perspective. What is this? One of the activities that some market analysts, known as technical analysts, undertake is to plot the movement of stock prices against time and try to predict future cycles 3
3 Suppose the price was 2.35 what should somebody who owns the stock do? The owner should clearly sell since this gives 2.35 whereas if the stock was held onto it would pay off 2.29 in terms of today's money. If everybody who owns the stock tries to sell the price will fall until it is equal to 2.29. Whenever prices get out of line with discounted cash flows there will be profit opportunities. The efficient markets hypothesis is essentially arguing these can't last for long. In other words arbitrage ensures that prices reflect discounted cash flows. If stock market prices reflect discounted cash flows then this implies the following. Implication of Efficient Markets Hypothesis: If a positive NPV project is accepted the value of the firm will increase by the amount of the project's NPV. Hence accepting positive NPV projects leads to an increase in stock price and the creation of shareholder wealth. Rejecting negative NPV projects avoids a fall in share price and the destruction of shareholder wealth. This fundamental view of the stock market is at the heart of most corporate finance theories. An alternative view is a technical perspective. What is this? One of the activities that some market analysts, known as technical analysts, undertake is to plot the movement of stock prices against time and try to predict future cycles
STOCK PRICE NOV TIME Suppose you discover a cycle, and at the present moment the stock is at the bottom of a trough. What should you do? You should buy the stock in anticipation of it going up. But what happens if there are a lot of technical analysts and many people do this? The price rises until it offers only a normal rate of return. In other words, any cycles will self-destruct because many people will be doing this. People will arbitrage away profit opportunities Competition in technical research will tend to ensure that current prices reflect all information in the past sequence of prices and that price changes cannot be predicted from past prices This is called the weak form of market efficiency: Current prices reflect all the information contained in the record of past prices. Predictable cycles are eliminated because otherwise positive NPV transactions would exist. If this is the case, why do stock prices change? Efficient markets theory argues they change because new information is received They must change as soon as the information is received and fully reflect this information otherwise positive NPV transactions would again exist. The semi-strong form of market efficiency is that current prices reflect not only past prices but all other published
4 Suppose you discover a cycle, and at the present moment the stock is at the bottom of a trough. What should you do? You should buy the stock in anticipation of it going up. But what happens if there are a lot of technical analysts and many people do this? The price rises until it offers only a normal rate of return. In other words, any cycles will self-destruct because many people will be doing this. People will arbitrage away profit opportunities. Competition in technical research will tend to ensure that current prices reflect all information in the past sequence of prices and that price changes cannot be predicted from past prices. This is called the weak form of market efficiency: Current prices reflect all the information contained in the record of past prices. Predictable cycles are eliminated because otherwise positive NPV transactions would exist. If this is the case, why do stock prices change? Efficient markets theory argues they change because new information is received. They must change as soon as the information is received and fully reflect this information, otherwise positive NPV transactions would again exist. The semi-strong form of market efficiency is that current prices reflect not only past prices but all other published STOCK PRICE NOW TIME
information. The strong form of efficiency is when prices reflect not just public information but all the information such as that which can be acquired by painstaking fundamental analysis of the company and the economy New information cannot by definition be predicted ahead of time since otherwise it would not be new information. Therefore, price changes cannot be predicted ahead of time Series of price changes must be random. To put it another way, if stock prices already reflect all that is predictable, then stock price changes must reflect only the unpredictable--they must e random What sort of path of prices do you get if price changes are random and occur only when there is new information? Prices follow a random walk. In the 1970s there was an immense amount of empirical work done by Fama and others to determine whether the evidence supports market efficiency or a technical view. The interpretation of the evidence amassed was that it provided substantial support for weak-form market efficiency. Semi- strong efficiency also had substantial support. The evidence for strong-form efficiency was more in dispute To summarize, we have said that theoretically prices should reflect available information since otherwise people would be able to make arbitrage trades and profit from hem. Another way of thinking about efficient markets is that the purchase or sale of a ecurity at the prevailing market price is a zero NPv transaction. Most finance academics would agree that empirically there appears to be strong support for this proposition The efficient market hypothesis has a number of implications that go against what many practitioners commonly suppose about financial markets. We shall now take a brief look at some of the most important of these
5 information. The strong form of efficiency is when prices reflect not just public information but all the information such as that which can be acquired by painstaking fundamental analysis of the company and the economy. New information cannot by definition be predicted ahead of time since otherwise it would not be new information. Therefore, price changes cannot be predicted ahead of time. Series of price changes must be random. To put it another way, if stock prices already reflect all that is predictable, then stock price changes must reflect only the unpredictable--they must be random. What sort of path of prices do you get if price changes are random and occur only when there is new information? Prices follow a random walk. In the 1970’s there was an immense amount of empirical work done by Fama and others to determine whether the evidence supports market efficiency or a technical view. The interpretation of the evidence amassed was that it provided substantial support for weak-form market efficiency. Semistrong efficiency also had substantial support. The evidence for strong-form efficiency was more in dispute. To summarize, we have said that theoretically prices should reflect available information since otherwise people would be able to make arbitrage trades and profit from them. Another way of thinking about efficient markets is that the purchase or sale of a security at the prevailing market price is a zero NPV transaction. Most finance academics would agree that empirically there appears to be strong support for this proposition. The efficient market hypothesis has a number of implications that go against what many practitioners commonly suppose about financial markets. We shall now take a brief look at some of the most important of these