Chapter 13

Principles of
Corporate Finance

Efficient Markets
and Behavioral
Finance
 13-2

Topics Covered
We Always Come Back to NPV
What is an Efficient Market?
– Random Walk
– Efficient Market Theory
The Evidence Against Market Efficiency
Behavioral Finance
Five Lessons of Market Efficiency
 13-3

Come back 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?

NPV  amount borrowed - PV of interest pmts

- PV of loan repayment
 13-4

Come back 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%.

 10 3,000  100,000
NPV  100,000   t
 10
 t 1 (1. 10 )  (1. 10 )
 100,000  56,988
 $43,012
 13-5

Come back to NPV

Investment v.s Financing Decisions
− Investment decisions are simpler than financing
decisions
− Financing decisions are much easier than
investment decisions
− They are easier to reverse. That is, their abandonment
value is higher
− Second, it’s harder to make money by smart financing
strategies

.
−
 13-6

What Is an Efficient Market?

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.
– Maurice Kendall suggest that the price changes
are independent of one another just as the gains
and losses in our coin-tossing game were
independent
 13-7

Random Walk Theory

Coin Toss Game Heads
$106.09
Heads
$103.00

$100.43
Tails
$100.00
Heads
$100.43
$97.50
Tails
$95.06
Tails
 13-8

Random Walk Theory

Microsoft (correlation = -.019)
5%
4%
3%
2%
1%
0%
-1%
-2%
-3%
-4%
-5%
-5% -3% -1% 1% 3% 5%
Jan 1, 1990 - May 14,
2009
 13-9

Random Walk Theory

Sony (correlation = 0.026)

5%

4%

3%

2%

1%

0%

-1%

-2%

-3%

-4%

-5%
-5% -3% -1% 1% 3% 5%
Jan 1, 1990 - May 14,
2009
 13-10

Random Walk Theory

BP (correlation = .004)
5%

4%

3%

2%

1%

0%

-1%

-2%

-3%

-4%

-5%
-5% -3% -1% 1% 3% 5%
Jan 1, 1990 - May 14,
2009
 13-11

Random Walk Theory

Philips Electronics (correlation = -0.03)

5%

4%

3%

2%

1%

0%

-1%

-2%

-3%

-4%

-5%
-5% -3% -1% 1% 3% 5%
Jan.1, 1990 - May 14, 2009
 13-12

Efficient Market Theory

Microsoft Stock
Price

$40
Actual price as soon as upswing is
recognized

30

Upswing

Cycles 20
disappear
once
identified

Last This Next

Month Month Month
 13-13

Efficient Market Theory

A market in which stock prices fully reflect
information is termed an efficient market.
 Levels of Market efficiency
– 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
 13-14

Efficient Market Theory

Implication of efficient market:

Expected return      return on market index

Abnormal return  actual stock return - expected stock return

~r (   ~ rm )
This abnormal return should reflect firm-specific news only

In an efficient market it is not possible to find expected returns greater (or less) than the
risk-adjusted opportunity cost of capital.
 13-15

Efficient Market Theory

39
Cumulative Abnormal Return Announcement
34
Date
29
24
19
(%)

14
9
4
-1
-6
-11
-16
Days Relative to annoncement date

The abnormal return on a sample of nearly 17,000

firms that were targets of takeover attempts
 13-16

Efficient Market Theory

Average Annual Return on Mutual Funds and the
Market Index
 13-17

Efficient Market Theory

 Professional and individual investors simply “buy the
index,” which maximizes diversification and cuts costs to
the bone?
 How far could indexing go? Not to 100%
 An efficient market needs some smart gather information
and attempt to profit.
 To provide incentives to gather costly information, prices
cannot reflect all information.
 But if the costs of information small, relative to the total
market value of traded securities, then the financial market
can still be close to perfectly efficient.
 13-18

Evidence against Market Efficiency

Anomalies

 Fundamental value = Market price: Expected return =

opportunity cost of capital.
 If price is less than fundamental value, then investors can
earn more than the cost of capital.
 Any test of market efficiency is then a combined test of
efficiency and the asset pricing model (commonly CAPM).
 13-19

Evidence against Market Efficiency

 Small-size effect:
– since 1926 the stocks of the firms with the lowest
market capitalizations have performed substantially
better than those with the highest capitalizations.
 13-20

Evidence against Market Efficiency

 Small-size effect: some explanations
– a higher expected return from small firms to compensate
for some extra risk factor that is not captured in the simple
capital asset pricing model.
– the superior performance of small firms could simply be a
coincidence, a finding that stems from the efforts of many
researchers to find interesting patterns in the data.
– the small-firm effect could be an important exception to
the efficient-market theory.
 13-21

Evidence against Market Efficiency

 Do Investors Respond Slowly to New Information?
– IPO long term underperformance.
– Underreact with earnings announcement
 13-22

Evidence against Market Efficiency

 Bubbles and Market Efficiency
 Difficult to value common stocks
– Estimates of the expected rate of dividend growth would affect
considerably the value of common stocks.
 Two important consequence
– Investors are generally based on yesterday’s price, then adjust
upward or downward. If information arrives smoothly, then, as
time passes, investors become confident that today’s price
level is correct. But when investors lose confidence in the
benchmark of yesterday’s price, there may be a period of
confused trading and volatile prices before a new benchmark
is established.
– It impossible to test whether stocks are correctly valued. No
one can measure true value with any precise
 13-23

Evidence against Market Efficiency

2009 Recession

Div 217
PV ( stocks) May 2009    $7,000
r  g .072  .041

Div 217
PV ( stocks) growth drops    $6,028
r  g .072  .036
 13-24

Evidence against Market Efficiency

2000 Dot.Com Boom

Div 154.6
PV (index) March 2000    12,883
r  g .092  .08

Div 154.6
PV (index )October 2002    8,589
r  g .092  .074
 13-25

Evidence against Market Efficiency

1987 Stock Market Crash

Div 16.7
PV (index) pre crash    1193
r  g .114  .10

Div 16.7
PV (index ) post crash    928
r  g .114  .096
 13-26

Behavioral Finance
 Behavioral psychology
1. Attitudes towards risk
− Investors’ value is determined by losses or
gains.
− Investors are particularly averse to the
possibility of even very small loss and need a
high return to compensate for it.

PROSPECT THEORY
 13-27

Behavioral Finance
 Behavioral psychology
2. Beliefs about probabilities
− Investors may make systematic errors in
assessing the probability of uncertain event.
− when judging possible future outcomes,
individuals tend to look back at what happened
in a few similar situations.
− Investors are also too conservative, slowly
update new evidence.
− Investors are overconfident.
 13-28

Behavioral Finance
 Behavioral psychology
− Limits to arbitrage
 Incentive problems and the subprime crisis
 13-29

Lessons of Market Efficiency

Markets have no memory
Trust market prices
Read the entrails
The do it yourself alternative
Seen one stock, seen them all
 13-30

Lessons of Market Efficiency

Markets have no memory
− The weak form of the efficient-market hypothesis states
that the sequence of past price changes contains no
information about future changes.
− Sometimes financial managers seem to act as if this were
not the case
 after an abnormal market rise, managers prefer to issue equity
rather than debt.
 they are often reluctant to issue stock after a fall in price. They are
inclined to wait for a rebound.
 13-31

Lessons of Market Efficiency

Trust market prices
− In an efficient market you can trust prices, for they impound
all available information about the value of each security.
− This means that in an efficient market, there is no way for
most investors to achieve consistently superior rates of
return.
− Implications for:
 financial manager who is responsible for:
 the firm’s exchange-rate policy
 the firm’s purchases and sales of debt.
 purchasing another companies.
 13-32

Lessons of Market Efficiency

Read the entrails
− If the market is efficient, prices impound all available
information. Therefore, if we can only learn to read the
entrails, security prices can tell us a lot about the future.
− For example,
 information in a company’s financial statements can help the
financial manager to estimate the probability of bankruptcy.
 market’s assessment of the company’s securities can also provide
important information about the firm’s prospects.
 if the company’s bonds are trading at low prices, you can deduce
that the firm is probably in trouble
 13-33

Lessons of Market Efficiency

The do it yourself alternative
− In an efficient market investors will not pay others for what
they can do equally well themselves.
− For example,
− companies often justify mergers on the grounds that they produce a
more diversified and hence more stable firm. But if investors can
hold the stocks of both companies why should they thank the
companies for diversifying? It is much easier and cheaper for them
to diversify than it is for the firm.
 13-34

Lessons of Market Efficiency

Seen one stock, seen them all
− Investors don’t buy a stock for its unique qualities.
− they buy it because it offers the prospect of a fair return for
its risk.
− This means that stocks should be almost perfect substitutes.
− Therefore, the demand for a company’s stock should be
highly elastic. If its prospective return is too low relative to
its risk, nobody will want to hold that stock. If the reverse
is true, everybody will scramble to buy.