Market efficiency

• Market efficiency
– Types
– Efficient markets
– Implications
 WHAT IS AN EFFICIENT MARKET
• In mid-1960, Eugene Fama, introduced the concept of
market efficiency.
– Putting simply, the idea is that intense competition in the
capital market lead to the fair pricing of debt and equity
securities.

• An efficient market is one in which, the market price of

a security is an unbiased estimate of its intrinsic value.
– It doesn't mean that prices are equal to intrinsic value, but
errors are unbiased.
– Deviations are random and uncorrelated
• Criticism
– Benjamin Friedman, Efficient market hypothesis is a
credo- a statement of faith with no scientific proposition.
– Warren Buffet, market is slough of fear and greed
untethered to corporate reality.

• Limitation
– Under the influence of investors' sentiments, stock prices
often vary more than what is warranted by
fundamentals.
 Types of market efficiency
• Fama distinguishes three levels of market efficiency.
– Weak-form efficiency
• Prices reflect each and every information
• Market returns are independent; returns of different period are not
related.

– Semi-strong form efficiency

• Stock prices reflect all publically available information
• i.e. All investors will react to the announcement of an event, thus,
reducing possibility of outperforming

– Strong-form efficiency
• Stock prices incorporate all private and public information.
• Investor cant earn abnormal returns even by possessing any new
information.
Efficient market: Implications for corporate
finance
• Creative accounting does not pay
• A firm cannot time its security issue
• The issue of security cannot depress the prices
RISK AND RETURN ANALYSIS
 Return
• Actual earnings or income received from an investment for a
given period.
• Composed of two components
– Regular or annual income or yield or dividend
= Div/Po*100
– Capital gain, i.e price changes
=(P1-Po)/Po*100

Total return=Dividend yield +Capital yield

=Di+(P1-Po)* 100
Po
 Types of return
• Ex-post return or actual return
After the event
Actual return
Ri=(P1-Po)/Po*100
• Ex-ante returns or expected returns
Anticipated returns or expected returns
Mean return; ∑R/N or ∑pr*Ri
 Expected returns

Particulars Probability Asset A Asset B Return A Return B

Annual returns
(%)      
Pessimistic 0.20 14.00 8.00 2.80 1.60
Most likely 0.60 16.00 16.00 9.60 9.60
Optimistic 0.20 18.00 24.00 3.60 4.80
Expected returns 16.00 16.00 16.00 16.00
 Key consideration for risk
• Financial assets are expected to generate cash flows; thus, there lies riskiness of
uncertainty in the realization of expected inflows.

• Riskiness of asset could be measured as standalone or in portfolio context, when asset

forms the part of large portfolio. A highly risky asset may be less risky when it is a part
of large portfolio.

• Risk is of two types

– Diversifiable
– Non-diversifiable or market or systematic risk
– For an investor diversifiable risk matters

• In general, investors are risk averse; they want to be compensated for bearing market
risk.

• High the market risk, higher is the return.

 Certainty equivalent
• Assured amount for expected uncertain
return.
– If CE< Expected uncertain return, investor is risk
averse
– If CE=Expected uncertain return, investor is
indifferent
– If CE>Expected uncertain return, investor is risk
loving
 Risk
• Uncertainty in the expected outcome
• Variability in actual returns from the expected
outcomes
• Measure= standard deviation = √∑((Ri-R’)^2)/n

Or √∑Pr*((Ri-R’)^2)
• Measure of relative risk:
– Coefficient of variation= (SD/ R’) *100
Particulars Probability Asset A Asset B A B
Annual returns (%)       Pr*(Ri-Ri')^2
Pessimistic 0.20 14.00 8.00 0.80 12.80
Most likely 0.60 16.00 16.00 - -
Optimistic 0.20 18.00 24.00 0.80 12.80
Expected returns 16.00 16.00 1.60 25.60
Risk =SD 1.26 5.06
 Portfolio Risk and return

Expected portfolio return  ( w1 r1 )  ( w 2 r2 )

Portfolio variance  W12σ12  W22σ 22  2(W1W2ρ12σ1σ 2 )

ρ12 σ 1σ 2  Covariance ; ρ12  correlatio n

 Calculating Portfolio Risk
• Example Correlation Coefficient = 0.4

Stocks SD % of Portfolio Average Return

ABC Corp 28 60% 15%

Big Corp 42 40% 21%

 Calculating Portfolio Risk
• Example Correlation Coefficient = 0.4

Stocks SD % of Portfolio Average Return

ABC Corp 28 60% 15%
Big Corp 42 40% 21%

• Return: r = (15%)(.60) + (21%)(.4) = 17.4%

• Portfolio Variance:
= (282)(.62) + (422)(.42) + 2(.4)(.6)(28)(42)(.4)
= 28.1
 Cash flows
• Profit vs Cash flows
• Cash flow estimation
• Principles
– Separation
– Incremental
– After tax
– Consistency

• Biases
 Dividends versus FCF
• Dividends
– Cash Flows Actually Paid to Stockholders

• Free Cash Flows

– Cash Flows Available for Distribution
– Reflect ability to pay dividends, not what was
actually paid

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The Free Cash Flow Method

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 FCFF versus FCFE
• Free Cash Flow–Firm (FCFF)
– Enterprise Cash Flow
– Value the Entire Firm

• Free Cash Flow–Equity (FCFE)

– Value Equity
– Issue: Preferred Shares

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 Free Cash Flow–Firm (FCFF)
• Cash Flow Available to…
– Repay Lenders
– Pay Common and Preferred Dividends
– Repurchase Equity
– Call Debt
• Adjustments to Net Income
– Interest and Principal Payments
– Non-Cash Items
– Δ Working Capital
– Δ Capital Expenditures

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Free Cash Flow–Firm (FCFF)
Net Income
+ Interest and Principal Payments

+ Non-Cash Items (e.g., Depreciation)

– ΔNet Working Capital

– Δ Capital Expenditures
FCFF

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 Free Cash Flow–Equity (FCFE)
• Cash Flow Available to…
– Repay Lenders
– Pay Common and Preferred Dividends
– Repurchase Equity
• Adjustments to Net Income
– Interest and Principal Payments
– Non-Cash Items
– Δ Working Capital
– Δ Capital Expenditures

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Free Cash Flow–Equity (FCFE)
Net Income
+ Non-Cash Items (e.g., Depreciation)

– ΔNet Working Capital

– Δ Capital Expenditures
FCFE

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 Alternate FCFE Method
• Derive Value form FCFF

FCFF

– Value of Debt

FCFE

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 The Cash Flows
• The Income Statement
– Net Income
– Use This Method

• The Statement of Cash Flows

– Cash Flow from Operations

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 Interest and Principal Payments
• After Tax Interest Payment
– Interest x (1 – tc)

• Principal Repayment?
– Target Capital Structure

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 Non-Cash Adjustments
Non-Cash Item Adjustment to Net Income
Depreciation Added Back
Amortization of intangibles Added Back
Restructuring Charges (expense) Added Back
Losses Added Back
Gains Subtracted
Amortization of long-term bond discounts Added Back
Amortization of long-term bond premium Subtracted
Deferred Taxes None

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 Forecasting Cash Flows
• Historical Data
– Historical Growth Rate
– Best for Constant Growth
– Past Predictive of Future

• New Information

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 Forecasting Capital Expenditures
• Two Components
– Net Expenditures to Maintain Assets-in-Place

– New Expenditures to Support Growth

Opportunities

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 Terminal value
• Firms are Infinite

• Perpetuity or Growing Perpetuity

• WARNING: Delayed Perpetuity

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 Discount Rate
• FCFF
– WACC

• FCFE
– Required Return on Equity

• More in Cost of Capital

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Problems with Free Cash Flow

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 Technical Problems
• Free cash flow forecasts are generally not
available
• Generally must compute statement of cash
flows from:
– earnings forecasts
– balance sheet assumptions
• Much of value comes far in the future
 Capital Expenditures
• “Cash flow available to the firm’s suppliers of
capital after all operating expenses have been
paid and necessary investments in working
capital and fixed capital have been made.”
• What is ‘necessary’?”

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 Growth Estimation
• Past versus Future

• Sensitivity

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Free Cash Flow Example

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 Income Statement
Income Statement
Revenues $644,400,000
Costs and operating expenses
Cost of product sales $294,200,000
Selling, general and administrative $92,900,000
Depreciation and amortization $20,000,000
Research and development $44,400,000
Bad debt provisions $200,000
Total costs and operating expenses $451,700,000
Operating income $192,700,000
Other income (expense)
Interest income $15,900,000
Interest expense ($11,300,000)

Other $700,000
Total other income (expense) $5,300,000
Income before tax $198,000,000
Income tax provisions $74,000,000
Net income $124,000,000
Dividends $24,000,000

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 Parameters
• Rates
– WACC 12%
– Return on Equity 17%
• Adjustments
– ΔNet Working Capital $5,000,000
– ΔCapital Expenditures $35,000,000
• Growth Rates
– g1-4 20%
– g5+ 2%
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 Initial FCFF
FCFF
Interest and Principal Payments $7,076,768 +
Depreciation $20,000,000 +
D Net Working Capital $5,000,000 –
D Capital Expenditures $35,000,000 –
FCFF 111,076,768
Note: Interest and Principal Payments are After-Tax

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 FCFF Valuation

FCFF Model
1 2 3 4 5+
Growth 20% 20% 20% 20% 2%
FCFF $133,292,121 $159,950,545 $191,940,655 $230,328,785 $234,935,361
Terminal Value $2,349,353,612
PV (Annual) $119,010,823 $127,511,596 $136,619,567 $146,378,107 $1,493,056,693
PV (ST) $529,520,092
PV (LT) $1,493,056,693
Value $2,022,576,785

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 Initial FCFE

FCFE
Depreciation $20,000,000 +
D Net Working Capital $5,000,000 –
D Capital Expenditures $35,000,000 –
FCFF $104,000,000

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 FCFE Valuation

FCFE Model
1 2 3 4 5+
Growth 20% 20% 20% 20% 2%
FCFF $124,800,000 $149,760,000 $179,712,000 $215,654,400 $219,967,488
Terminal Value $1,466,449,920
PV (Annual) $106,666,667 $109,401,709 $112,206,881 $115,083,981 $782,571,071
PV (ST) $443,359,238
PV (LT) $782,571,071
Value $1,225,930,309

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 FCF for the ABC Company
Suppose analysts have constructed pro forma financial statements for the ABC
Company and report the following:

From the pro forma income statement From the pro forma income statement
Net income $40 Change in deferred taxes $3
Interest expense $5 Depreciation $10
Interest income $2 Change in working capital $6
Capital expenditures $20
Assumed
Tax rate = 45%

What is ABC’s free cash flow?

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 Example: FCF
Net income $40.00
Plus Net interest after tax 1.65
Equals Unlevered net income $41.65
Plus Change in deferred taxes 3.00
Equals Net operating profit minus adjusted taxes $44.65
Plus Depreciation 10.00
Minus Change in working capital 6.00
Minus Capital expenditures 20.00
Equals Free cash flow $28.65

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 Negative cash flows
• Negative cash flows from operations are prima-facie
suggestive of operating problems.
• Negative free cash flows from investment is not a
concern if rate of return is satisfactory.

• Return on invested capital

• Net operating profit after taxes*100
Operating capital
If Returns >WACC, investment is profitable