You are on page 1of 44

Graduate School of Business and Law


BUSM4160 Managerial Finance

Topic 8: Efficient Capital Markets & Long
Term Financing
1. The efficient market hypothesis (EMH)
2. Different types of efficiency
3. Behavioral challenges
4. Implications of EMH to corporate finance
5. Long-term financing
6. The initial public offering (IPO)
This covers aspects from textbook chapters 14,15 & 20!

1. The efficient market hypothesis (EMH)

Can Financing Decisions Create Value?

So far we covered finance principles (TVM, risk & return)
and the investment decision (NPV rule)
The next few topics concern financing decisions, such as:
How much debt and equity to sell
When to sell debt and equity
When (or if) to pay dividends

Can these decisions create value?

1. The efficient market hypothesis (EMH)

Financial Market
Buyers and seller comes together
Often no physical location
SEATS (Stock Exchange Automated Trading System)
A primary market is where securities are traded for the first
time (e.g. Treasury notes sold by the RBA in tenders).
A secondary market is where subsequent trading of
securities occurs (e.g. sale of Treasury notes from one
dealer to another in the money market).

1. The efficient market hypothesis (EMH)

Financial Market ASX

The listed market (ASX)

2006:1758 (1,207 billion)

Other listed
Equity investments Debt securities

Ordinary shares Bonds (govts)

Contributing shares Debentures (Business)
Preference shares and
Financial futures
Rights Notes
Company options
Property and equity

1. The efficient market hypothesis (EMH)

An efficient capital market is one in which stock

prices fully reflect available information (Fama,
1970; 1991)
Foundations for efficiency: (1) Investor rationality,
(2) independence of events & (3) arbitrage
EMH has implications for investors and firms.
Since information is reflected in security prices quickly, knowing
information that has been released does an investor no good.
Firms should expect to receive the fair value for securities that
they sell. Firms cannot profit from fooling investors in an efficient

1. The efficient market hypothesis (EMH)
Stock reaction to good news
Overreaction to good
news with reversion

response to
Efficient market good news
response to good news

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

Days before (-) and after (+)
1. The efficient market hypothesis (EMH)
Stock reaction to bad news
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 (+) announcement
2. The different types of efficiency

Information sets
All information
Weak form relevant to a stock

Semi-strong form
Information set
Strong-form of publicly available

set of
past prices

2. Different types of efficiency

Weak form of market efficiency

Security prices reflect all information found in past
prices and volume.
Pt = P t-1 + Expected return + random error t
If the weak for of market efficiency holds, then
technical analysis is of no value.
Since stock prices only respond to new
information, which by definition arrives randomly,
stock prices are said to follow a random walk.

2. Different types of efficiency
Weak form of market efficiency
Investor behavior tends to eliminate any profit
opportunity associated with stock price patterns.
Stock Price

If it were possible to make

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

2. Different types of efficiency

Semi-strong form of market efficiency

Security prices reflect all publically available
information, which includes:
Historical price and volume information
Published accounting statements
Information found in annual reports

2. Different types of efficiency

Strong-form of market efficiency

Security prices reflect all available information
public and private.
Strong form efficiency incorporates weak and
semi-strong form efficiency.
Strong form efficiency states that anything
pertinent to the stock and know to at least one
investor is already incorporated into the securitys

2. Different types of efficiency
What the EMH Does and Does NOT Say
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 or uncaused.

Prices reflect information.
The price CHANGE is driven by new info, which by definition
arrives randomly.
Therefore, financial managers cannot time stock and bond

2. Different types of efficiency
Empirical evidence on EHM is extensive, and in
large measure, it is reassuring to advocated of the
efficiency of markets
Categories of studies:
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.

2. Different types of efficiency
Event study methodology has been applied to a large
number of events including:
Dividend increases and decreases
Earnings announcements
Capital Spending
New Issues of Stock
The studies generally support the view that the
market is semi-strong form efficient.
Studies suggest that markets may even have some
foresight into the future, i.e., news tends to leak out
in advance of public announcements.
2. Different types of efficiency
The record of mutual funds: If the market is semi-
strong 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.
Overall result: Mutual funds do not beat indices.

2. Different types of efficiency
Insider trading: 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.

3. Behavioral challenges
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
Behavioral bias
Overconfidence overestimate ability to pick stocks
Disposition effect: Regret and pride in trading
Familiarity (home bias)
Representativeness (overreaction)
Conservatism (underreaction)
Risk taking increase risk after gains, reduce risk after
3. Behavioral challenges
Financial Economists have sorted themselves into
three camps:
1. Market efficiency
2. Behavioral finance
3. Those that admit that they do not know
This is perhaps the most contentious area in the
What are the implications for corporate finance?

4. Implications of EMH to corporate finance
If 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.

4. Implications of EMH to corporate finance
The EMH has important implications for corporate
1. Prices reflect underlying value.
2. The price of a companys stock cannot be affected
by a change in accounting (creative accounting).
3. Financial managers cannot time issues of stocks
and bonds using publicly available information.

5. Long term financing: Debt vs equity
Debt Equity
Not an ownership interest Ownership interest
Creditors do not have Common stockholders vote
voting rights for the board of directors
Interest is considered a and other issues
cost of doing business and Dividends are not
is tax deductible considered a cost of doing
Creditors have legal business and are not tax
recourse if interest or deductible
principal payments are
missed Dividends are not a liability
of the firm, and
Excess debt can lead to stockholders have no legal
financial distress and
bankruptcy recourse if dividends are
not paid
An all-equity firm cannot go

5. Long term financing: Debt vs equity
Debtors stand ahead of equity holders to income stream
and assets.
Interest is tax deductible.
Effect of debt on control - lenders have no voting rights,
but large degree of potential control if the company
breaches a loan agreement
Financial risk: Risk attributable to the use of debt as a
source of finance; two components of financial risk:
1. Leverage effect
2. Financial distress effect

5. Long term financing: Sources
1. Internal Funds: Cash, Retained earnings
2. External Debt: Bank borrowings or issue new debt
3. Issue Equity: Public offering or private placement
4. Venture Capital: A venture capital firm specialises
in raising money to invest in the private equity of
young firms.

5. Long term financing: Patterns
Internally generated CF dominates as a source of
financing, typically between 70 - 90%.
But, firms usually spend more, the deficit is financed
first by new sales of debt and lastly, new equity.
The Pecking Order Theory - firms first finance projects
out of retained earnings. This will lower the % of debt in
the capital structure as profitable, internally funded
projects raise both the BV & MV.
Additional CF needs are met with debt, when debt
capacity exhausted at some point & equity issuance to

6. The initial public offering (IPO)
The process of selling stock to the public for the first
time is called an initial public offering (IPO) or flotation.
The shares sold at an IPO may either be new shares
that raise new capital, known as a primary offering, or
existing shares that are sold by current shareholders,
known as a secondary offering.
A primary offering is used to:
Convert a private company to a public company
Spin-off a portion of the business of a listed company
Form a new company
Privatise a public organisation

6. The initial public offering (IPO)
Secondary issues
Term used for all issues by a company subsequent to
its listing.
Principal forms of secondary issues are:
Private placements: Sale of securities to selected
clients of a sharebroker and/ or large institutional
investors (e.g. superannuation funds).
Rights issues: Issues of shares made to all existing
shareholders, who are entitled to take up new
shares in proportion to their present holdings.

6. The initial public offering (IPO)
Advantages of public company listing
Greater liquidity
Better access to additional capital
Growth not limited by cash resources
Enhancement of corporate image
Can attract and retain key personnel
Gain independence from a spin-off

6. The initial public offering (IPO)
Disadvantages of public company listing
Dilution of control of existing owners
Additional responsibilities of directors
Greater disclosure of information
Explicit costs
Insider trading implications

6. The initial public offering (IPO)
Underwriters and managers
Many IPOs are managed by a group of underwriters, who
act as intermediaries:
Pricing the issue
Marketing the issue
Engaging sub-underwriters
Placing the shortfall
Underwriters, such as Credit Suisse or Macquarie Bank,
may take up any shares not taken up by investors under the
IPO and actively participate in determining the offer price.
Prospectus: document issued by the company setting out
the terms of its equity issue, must be lodged with both ASIC
and the ASX.
6. The initial public offering (IPO)
Valuation and underpricing
Many IPOs are managed by a group of underwriters,
who work with the company to come up with a price
that they believe is a reasonable valuation for the firm.
Two ways used to value a company:
1. Estimate the future cash flows and calculate the present
value, or
2. Examine comparable companies.

Determining the correct offering price is difficult.

1. If the issue is priced too high, it may be unsuccessful and
has to be withdrawn;
2. If the issues is priced too low, existing shareholders loose
6. The initial public offering (IPO)
Valuation and underpricing
May be difficult to price an IPO because there is not a
current market price available.
Private companies tend to have more asymmetric
information than companies that are already publicly
Underwriters want to ensure that, on average, their
clients earn a good return on IPOs.
Underpricing causes the issuer to leave money on the

6. The initial public offering (IPO)
IPO puzzles - Four characteristics of IPOs puzzle financial
1. On average, IPOs appear to be underpriced: The price at the
end of trading on the first day is often substantially higher than
the IPO price.
2. The number of IPOs is highly cyclical: When times are good,
the market is flooded with IPOs; when times are bad, the
number of IPOs dries up.
3. The costs of the IPO are very high: It is unclear why firms
willingly incur such high costs.
4. The long-run performance of a newly public company (3 - 5
years from the date of issue) is poor: That is, on average, a
long run buy-and-hold strategy appears to be a bad
6. The initial public offering (IPO)
Underpriced IPOs
Generally, underwriters set the issue price so that the
average first-day return is positive.
In Australia, several studies have examined the underpricing
of IPOs and found that, on average, they are underpriced by
Note that, although underpricing is a persistent and global
phenomenon, it is generally smaller in more developed
capital markets.

Who wins and who loses because of underpricing?

6. The initial public offering (IPO)
Figure 1. Average first day returns around the world

6. The initial public offering (IPO)
Hotandcold IPO markets
As with all market activity, trends related to the number of
IPO issues are cyclical with a large magnitude of swings.
It appears that the number of IPOs is not solely driven by
the demand for capital.
Sometimes, firms and investors seem to favour IPOs. At
other times, firms appear to rely on alternative sources of

6. The initial public offering (IPO)

Figure 2. Number of IPOs in Australia, 200307

6. The initial public offering (IPO)
High costs of IPOs
In the US, the discount below the issue price at which the
underwriter purchases the shares from the issuing firm is
7% of the issue price.
The typical spread in Australia is about 4%.
This fee covers the cost to the underwriter of managing the
syndicate of managers and helping the company prepare for
the IPO.
Still, this fee is largeespecially considering the additional
cost to the firm associated with underpricing.

6. The initial public offering (IPO)
Figure 3. Relative costs of issuing securities

6. The initial public offering (IPO)
Poor post-IPO performance
Newly listed firms appear to perform relatively poorly over
the following three to five years after their IPOsso why do
investors pay as much as they do for the shares when they
begin trading?

Possibly, that underperformance might not result from the

issue of equity itself, but rather from the conditions that
motivated the equity issuance in the first place.

6. The initial public offering (IPO)
Raising additional equity
A firms need for outside capital rarely ends at the IPO as
profitable growth opportunities occur throughout the life of
the firm.
Seasoned equity offering (SEO): When firms return to the
equity markets and offer new shares for sale.

1. Cash offer: the firm offers new shares to investors at

2. Rights offer: the firm offers the new shares only to
existing shareholders. Rights offers protect
shareholders from underpricing.

6. The initial public offering (IPO)
Raising additional equity
On average, the market greets the news of an SEO with a
The market value of existing equity drops on the
announcement of a new issue of common stock.
Reasons include:
Managerial Information: managers are the insiders,
perhaps they are selling new stock because they think
it is overpriced.
Debt Capacity: If the market infers that managers issue
new equity to reduce their debt-equity ratio to reduce
financial distress, the stock price will fall.
Issue Costs (3 -5% for issuance of >100m.)

End of Topic 8
Please revise:
RWJ10e Ch.9 (Stock Valuation)
Exercise and Discussion Questions:
Ch.9 (P299-303): Q11, Q19 & Q36