Chapter 14

Corporate Financing Decisions and

Efficient Capital Markets
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Chapter Outline
14.1 Can Financing Decisions Create Value?
14.2 A Description of Efficient Capital Markets
14.3 The Different Types of Efficiency
14.4 The Evidence
14.5 The Behavioral Challenge to Market Efficiency
14.6 Empirical Challenges to Market Efficiency
14.7 Reviewing the Differences
14.8 Implications for Corporate Finance
14.9 Summary and Conclusions
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Can Financing Decisions Create
Value?
• Earlier lectures covered how to evaluate investment
projects according to NPV criterion.
• Now we look at financing decisions.
• Capital structure decision: how can the firm raise
the money for the required investments?

Section 14.1 14-3

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What Sort of Financing
Decisions?
• Typical financing decisions include:
– How much debt and equity to sell?
– When (or if) to pay dividends?
– When to sell debt and equity?

• Just as we can use NPV criteria to evaluate

investment decisions, we can use NPV to evaluate
financing decisions.

Section 14.1 14-4

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How to Create Value through
Financing
• Fool Investors
– Empirical evidence suggests that it is hard to fool
investors consistently.
• Reduce Costs or Increase Subsidies
– Certain forms of financing have tax advantages or carry
other subsidies.
• Create a New Security
– Sometimes a firm can find a previously unsatisfied
clientele and issue new securities at favourable prices.
– In the long-run, this value creation is relatively small,
however.
Section 14.1 14-5
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A Description of Efficient Capital
Markets
• An efficient capital market is one in which share
prices fully reflect available information.
• The EMH has implications for investors and firms.
– Since information is reflected in security prices
immediately and correctly investors should only expect a
normal rate of return. Being aware of information when
it is released does an investor no good.
– Firms should expect to receive the fair value (i.e. present
values) for securities that they sell. Firms cannot profit
from fooling investors in an efficient market.

Section 14.2 14-6

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Foundations of Market Efficiency

• Three conditions cause market efficiency:
1. Investor rationality
– When new information is released, all investors will
adjust their estimates of share prices in a rational manner.
2. Independent deviations from rationality
– Investors will react in different ways, since they will
interpret information differently. But in total, these
reactions will all counter balance. As such, an efficient
market does not require rational individuals.
3. Arbitrage
– The arbitrage of professionals will dominate and the
markets will be efficient.
Section 14.2 14-7
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8-8 Fig. 14.1: Reaction of Stock Price to New
Information in Efficient and Inefficient
Markets (1 of 2)
Stock
Price Overreaction to “good
news” with reversion

Delayed
response to
“good news”
Efficient market
response to “good news”

-30 -20 -10 0 +10 +20 +30

Days before (-) and
after (+)
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Section 14.2 announcement
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8-9 Fig. 14.1: Reaction of Stock Price to New
Information in Efficient and Inefficient
Markets (2 of 2)
Stock Efficient market
response to “bad news” Delayed
Price response to
“bad news”

-30 -20 -10 0 +10 +20 +30

Overreaction to “bad Days before (-) and
news” with reversion after (+)
Section 14.2 announcement
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The Different Types of Efficiency

• Weak Form
– Security prices reflect all information found in past prices
and volume.
• Semi-Strong Form
– Security prices reflect all publicly available information.

• Strong Form
– Security prices reflect all information - public and
private.

Section 14.3 14-10

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Weak-Form Market Efficiency

Security prices reflect all information found in
past prices and volume.
• If the weak form of market efficiency holds, then
technical analysis is of no value.
• Often weak-form efficiency is represented as

Pt = Pt-1 + Expected return + random error

• Since stock prices only respond to new information,
which by definition arrives randomly, stock prices
are said to follow a random walk.
Section 14.3 14-11
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Why Technical Analysis Fails

• Investor behaviour tends to eliminate any profit
opportunity associated with stock price patterns.
Stock Price

If it were possible to make

Sell
big money simply by
Sell finding “the pattern” in the
stock price movements,
Buy everyone would do it and
the profits would be
Buy
competed away.

Time
Section 14.3 14-12
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Semistrong Form Market
Efficiency
Security prices reflect all publicly
available information.
• Publicly available information includes:
– Historical price and volume information
– Published accounting statements.
– Information found in annual reports.
– Information pertaining to the global/macroeconomic
environment, e.g., exchange rates, GDP growth, interest
rates, inflation, etc.

Section 14.3 14-13

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Strong-Form Market Efficiency
(1 of 2)
Security prices reflect all information -
public and private.
• Strong form efficiency incorporates weak and semi-
strong form efficiency.
• Strong form efficiency says that anything pertinent
to the share and known to at least one investor is
already incorporated into the security’s price.

Section 14.3 14-14

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Strong-Form Market Efficiency
(2 of 2)
• In reality, for the strong-form market efficiency
theory:
– It is difficult to believe that an investor with inside
information cannot profit.
– Difficult to find proof.
– If all information is already reflected in share prices,
there would be no incentive to expend resources to gather
information and trade on it.
• Suggests that markets cannot be strong-form
efficient.

Section 14.3 14-15

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8-16 Relationship among Three
Different Information Sets
(Fig. 14.3)
All information
relevant to a stock

Information set
of publicly available
information

Information
set of
past prices

Section 14.3 14-16

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Some Common Misconceptions

• Much of the criticism of the EMH has been based
on a misunderstanding of what the hypothesis says
and does not say.
• Three misconceptions:
– The efficacy of dart throwing
– Price fluctuations
– Shareholder disinterest

Section 14.3 14-17

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What the EMH Does and Does
NOT Say (1 of 2)
• Investors can throw darts to select stocks.
– This is almost, but not quite, true.
– An investor must still decide how risky a portfolio he
wants based on risk aversion and the level of expected
return.
• Prices are random.
– Prices reflect information.
– The price CHANGE is driven by new information, which
by definition arrives randomly.
– Therefore, financial mangers cannot “time” stock and
bond sales.

Section 14.3 14-18

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What the EMH Does and Does
NOT Say (2 of 2)
• Shareholder disinterest
– Skeptical that market price can be efficient when only a
fraction of outstanding shares change hands on any given
day.
– But trades are only done when the investor’s appraised
value differs from the market price.
– The market can still be efficient and reflect available
information even with few trades.

Section 14.3 14-19

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The Evidence
• The studies on the EMH are extensive, and
generally reassuring to advocates of the efficiency
of markets.
• Studies fall into four broad categories:
1. Are changes in stock prices random? Are there
profitable “trading rules”?
2. Event studies: does the market quickly and accurately
respond to new information?
3. The record of professionally managed investment firms
and whether they beat the market.
4. Anomalies - evidence contrary to the EMH.

Section 14.4 14-20

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Weak Form: Are Changes in Stock
Prices Random?
• Can we really tell?
– Many psychologists and statisticians believe that most
people want to see patterns even when faced with pure
randomness.
– People claiming to see patterns in stock price movements
are probably seeing optical illusions.
• A matter of degree
– Even if we can spot patterns, we need to have returns that
beat our transaction costs.
• Random stock price changes support weak-form
efficiency.
Section 14.4 14-21
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Simulated and Actual Stock Price
Movements

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Section 14.4
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Semistrong Form: Event Studies

• Event studies are one type of test of the semi-strong
form of market efficiency.
– This form of the EMH implies that prices should reflect
all publicly available information.
• To test this, event studies examine prices and
returns over time - particularly around the arrival of
new information.
• Test for evidence of underreaction, overreaction,
early reaction, delayed reaction around the event.

Section 14.4 14-23

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How Event Studies Are Structured

• Returns are adjusted to determine if they are abnormal
by taking into account what the rest of the market did
that day.
• The Abnormal Return on a given stock for a particular
day can be calculated by subtracting the market’s return
on the same day (RM) from the actual return (R) on the
stock for that day:
AR = R – Rm
• The Abnormal Return can be also calculated using the
Market Model approach:
AR = R – (a + bRm)
• Cumulative abnormal returns = sum of abnormal
returns over the time period of interest. 14-24
Section 14.4
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Event Studies: Dividend
Omissions (Fig. 14.5)
Cumulative Abnormal Returns for Companies Announcing
Cumulative abnormal returns (%)

Dividend Omissions

1
0.146 0.108 0.032
-0.244
-0.483 0
-0.72
-8 -6 -4 -2 0 2 4 6 8
-1

-2
Efficient market
response to “bad news”
-3
-3.619

-4 -4.563-4.747-4.685-4.49
-5.015 -4.898
-5.183
-5 -5.411

-6
Days relative to announcement of dividend omission
S.H. Szewczyk, G.P. Tsetsekos, and Z. Santout “Do Dividend Omissions Signal Future Earnings or Past Earnings?” Journal
of Investing (Spring 1997)

Section 14.4 14-25

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Event Study Results (1 of 2)

• Over the years, event study methodology has been
applied to a large number of events including:
– Dividend increases and decreases
– Earnings announcements
– Mergers
– Capital spending
– New issues of stock

Section 14.4 14-26

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Event Study Results (2 of 2)

• Early studies generally supported the view that the
market is semistrong-form efficient.
• However, a number of more recent studies present
evidence that the market des not react to all relevant
information immediately.
• Difficult to interpret the evidence.

Section 14.4 14-27

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Semistrong Form: The Record of
Mutual Funds
• If the market is semistrong-form efficient, then no
matter what publicly available information mutual-
fund managers rely on to pick stocks, their average
returns should be the same as those of the average
investor in the market as a whole.
• We can test efficiency by comparing the
performance of professionally managed mutual
funds with the performance of a market index.

Section 14.4 14-28

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The Record of Mutual Funds
(1 of 2)

Section 14.4 14-29

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The Record of Mutual Funds
(2 of 2)
• Evidence finds that mutual funds do not beat broad-
based indexes on average.
– Consistent then with semistrong-form and weak-form
efficiency
• Implications
– Mutual funds permit individuals to buy a well-diversified
portfolio of a large number of shares.
– Growth in index funds
• Index fund: a type of mutual fund, which follows a passive
investment strategy of investing in the market index.

Section 14.4 14-30

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The Strong Form of the EMH

• One group of studies of strong-form market
efficiency investigates insider trading.
• A number of studies support the view that insider
trading is abnormally profitable.
• Thus, strong-form efficiency does not seem to be
substantiated by the evidence.
• Studies have also found that for large firms, the
probability of informed trading increases when the
CEO’s compensation is lower.

Section 14.4 14-31

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The Behavioral Challenge (1 of 4)

• Rationality
– People are not always rational.
– Many investors fail to diversify, trade too much, and
seem to try to maximize taxes by selling winners and
holding losers.
• Behavioural view is not that all investors are
irrational, but some are.

Section 14.5 14-32

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The Behavioral Challenge (2 of 4)

• Are deviations from rationality independent?
• Psychologists argue that people deviate from
rationality in predictable ways:
– Representativeness: drawing conclusions from too
little data
• This can lead to bubbles in security prices.
– Conservatism: people are too slow in adjusting their
beliefs to new information.
• Security prices seem to respond too slowly to earnings surprises.

Section 14.5 14-33

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The Behavioral Challenge (3 of 4)

• Arbitrage
– Suppose that your superior, rational analysis shows that
company ABC is overpriced.
– Arbitrage would suggest that you should short the shares.
– After the rest of the investors come to their senses, you
make money because you were smart enough to “sell
high and buy low.”
• But what if the rest of the investment community
does not come to their senses in time for you to
cover your short position?
– This makes arbitrage risky.

Section 14.5 14-34

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The Behavioral Challenge (4 of 4)

• Conclusion:
– The three conditions of market efficiency may not hold in
reality.
– That is, in reality,
• investors are irrational,
• irrationality may be related across investors rather than be
cancelled out, and
• arbitrage opportunities may be too risky to eliminate market
inefficiencies.

Section 14.5 14-35

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Empirical Challenge (1 of 2)
1. Limits to Arbitrage
– “Markets can stay irrational longer than you can stay
solvent.” John Maynard Keynes

2. Earnings Surprises
– Recent studies suggest that stock prices adjust slowly to
earnings announcements.
– Behavioralists claim that investors exhibit conservatism.

Section 14.6 14-36

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Empirical Challenge (2 of 2)
3. Size
– Small cap stocks seem to outperform large cap stocks.

4. Value Versus Growth

– High book value-to-share price stocks and/or high E/P
stocks outperform growth stocks.

5. Crashes and Bubbles

– Famous historical crashes and are still an enigma.

Section 14.6 14-37

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Limits to Arbitrage and the Law
of One Price: Example
• Law of one price: identical assets should
sell at identical prices.
• Siamese Twin Companies
– Royal Dutch should sell for 1.5 times Shell.
– Have deviated from parity ratio for extended
periods.
– Example of fundamental risk - intrinsic
value and market value may take too long to
converge.
Section 14.6 14-38
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Pricing of Royal Dutch Relative to
Shell

Section 14.6 14-39

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Crashes and Bubbles

• Crashes
– On October 19, 1987, the stock market dropped between
20 and 25 percent on a Monday following a weekend
during which little surprising news was released.
– A drop of this magnitude for no apparent reason is
inconsistent with market efficiency.
• Bubbles
– Some stock market crashes can be evidence consistent
with the bubble theory of speculative markets.
– Consider the tech stock bubble of 1999 – 2002 – was the
run up in prices due to “irrational exuberance?”
– But: no precise definition of a “bubble.”
Section 14.6 14-40
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Reviewing the Differences
(1 of 3)
• Financial Economists have sorted themselves into
three camps:
– Market efficiency
– Behavioral finance
– Those that admit that they do not know

• This is perhaps the most contentious area in the

field.

Section 14.7 14-41

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Reviewing the Differences
(2 of 3)
• Critics of behavioural finance argue:
1. The file drawer problem. The publication process of
selecting articles for journals that are unusual and
interesting may inadvertently favour behavioural
finance research.
2. Risk. EMH supporters suggest that market anomalies
that exist might disappear if more sophisticated
adjustments for risk were made.
3. Behavioural finance and market prices. Critics of
behavioural finance argue that even if the data support
certain anomalies, it is not clear that these anomalies
support behavioural finance.

Section 14.7 14-42

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Reviewing the Differences
(3 of 3)
• Adherents of behavioural finance argue that the
many uncovered anomalies are not mere chance
events.
– Representativeness (overweighting the results in a small
sample) which leads to overreaction in stock returns; or
– Conservatism – investors adjust their beliefs slowly
causing under-reaction.
• Critics of behavioural finance: which principle
should dominate in any particular situation?
• Overall, the jury is still out!!

Section 14.7 14-43

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Accounting and Efficient Markets

• Accounting standards allow firms with a significant
amount of leeway in reporting their results
• Accounting choices should not affect share price as
long as:
– Sufficient information is publicly available so that
analysts can construct earnings under alternative
accounting methods; and
– Markets are semi-strong efficient.

• Empirical evidence suggests that accounting

changes do not fool the market.

Section 14.8 14-44

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The Timing Decision (1 of 2)

• The timing decision – when should a company
issue equity?
– Ideally, equity should be issued when managers believe
their share is overpriced.
• If markets are efficient and shares are always
correctly priced, then the timing decision is
unimportant.

Section 14.8 14-45

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The Timing Decision (2 of 2)

• Evidence indicates that corporate mangers do issue
additional shares to the market (seasoned equity
offerings) when the shares are overpriced.
– Studies show a price drop on the announcement and
further price declines in the subsequent years.
• This evidence suggests that the market is inefficient
in the semi-strong form.

Section 14.8 14-46

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Speculation and Efficient Markets

• If markets are efficient, then managers should not:
– waste their time trying to forecast prices (i.e., foreign
currencies, or interest rates) in order to “beat” the market.
– acquire companies only because they are believed to be
underpriced.
• If stock prices reflect all available information, then
this information should be used as much as possible
in making corporate decisions.

Section 14.8 14-47

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Implications for Corporate
Finance (1 of 2)
• Because information is reflected in security prices
quickly, investors should only expect to obtain a
normal rate of return.
– Awareness of information when it is released does an
investor little good. The price adjusts before the investor
has time to act on it.
• Firms should expect to receive the fair value for
securities that they sell.
– Fair means that the price they receive for the securities
they issue is the present value.
– Thus, valuable financing opportunities that arise from
fooling investors are unavailable in efficient markets.
Section 14.8 14-48
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Implications for Corporate
Finance (2 of 2)
• The EMH has implications for corporate finance:

1. Prices reflect underlying value.

2. The price of a company’s share cannot be affected
by a change in accounting.
3. Financial managers cannot “time” issues of stocks
and bonds using publicly available information.
4. Managers cannot profitably speculate.

Section 14.8 14-49

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Why Doesn’t Everybody Believe
the EMH?
• There are optical illusions, mirages, and apparent
patterns in charts of stock market returns.
• The truth is less interesting.
• There is some evidence against market efficiency:
– Two different, but financially identical shares, trade at
different prices.
– Earnings surprises
– Small versus large stocks
– Value versus growth stocks
– Crashes and bubbles
• The tests of market efficiency are weak.
Section 14.8 14-50
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Summary and Conclusions
(1 of 2)
• An efficient market incorporates information in
security prices.
• There are three forms of the EMH:
– Weak-Form EMH
• Security prices reflect past price data.
– Semistrong-Form EMH
• Security prices reflect publicly available information.
– Strong-Form EMH
• Security prices reflect all information.

Section 14.9 14-51

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Summary and Conclusions
(2 of 2)
• There is abundant evidence for the first two forms
of the EMH.
• Behavioural Finance argues against market
efficiency.
– Investors are irrational
– Limits to arbitrage will not eliminate efficiencies

Section 14.9 14-52

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Quick Quiz
• Define capital market efficiency.
• What are the three forms of efficiency?
• What does the evidence say regarding the efficiency
of capital markets?
• What are the implications for corporate finance
managers?
• What is behavioural finance?

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