Principles of Corporate Finance Brealey and Myers Sixth Edition Corporate Financing and the Six Lessons of Market Efficiency Slides by Matthew Will Irwin/McGraw Hill Chapter 13 ©The McGraw-Hill Companies, Inc., 200 13- Topics Covered We Always Come Back to NPV What is an Efficient Market? Random Walk Efficient Market Theory The Evidence on Market Efficiency Six Lessons of Market Efficiency Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 13- Return to NPV NPV employs discount rates These discount rates are risk adjusted The risk adjustment is a byproduct of market established prices Adjustable discount rates change asset values Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 13- Return 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 Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 13- Return 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 ( 10 ) ( 10 ) t 1 100,000 56,988 $43,012 Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 13- 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 (skewed positive over the long term) Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 13- Random Walk Theory Coin Toss Game Heads Heads $106.09 $103.00 Tails $100.43 $100.00 Heads Tails $97.50 Tails Irwin/McGraw Hill $100.43 $95.06 ©The McGraw-Hill Companies, Inc., 200 13- Random Walk Theory S&P 500 Five Year Trend? or yrs of the Coin Toss Game? Level 180 130 80 Month Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 13- Random Walk Theory S&P 500 Five Year Trend? or yrs of the Coin Toss Game? Level 230 180 130 80 Month Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 13- 10 Irwin/McGraw Hill Random Walk Theory ©The McGraw-Hill Companies, Inc., 200 13- 11 Irwin/McGraw Hill Random Walk Theory ©The McGraw-Hill Companies, Inc., 200 13- 12 Irwin/McGraw Hill Random Walk Theory ©The McGraw-Hill Companies, Inc., 200 13- 13 Irwin/McGraw Hill Random Walk Theory ©The McGraw-Hill Companies, Inc., 200 13- 14 Irwin/McGraw Hill Random Walk Theory ©The McGraw-Hill Companies, Inc., 200 13- 15 Efficient Market Theory 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 Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 13- 16 Efficient Market Theory Fundamental Analysts Research the value of stocks using NPV and other measurements of cash flow Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 13- 17 Efficient Market Theory Technical Analysts Forecast stock prices based on the watching the fluctuations in historical prices (thus “wiggle watchers”) watchers Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 13- 18 Efficient Market Theory $90 Microsoft Stock Price 70 50 Cycles disappear once identified Irwin/McGraw Hill Last Month This Month Next Month ©The McGraw-Hill Companies, Inc., 200 13- 19 Efficient Market Theory Cumulative Abnormal Return (%) Announcement Date Irwin/McGraw Hill 39 34 29 24 19 14 -1 -6 -11 -16 Days Relative to annoncement date ©The McGraw-Hill Companies, Inc., 200 13- 20 Efficient Market Theory Average Annual Return on 1493 Mutual Funds and the Market Index 40 30 Return (%) 20 10 -10 Funds Market -20 -30 -40 19 Irwin/McGraw Hill 19 19 ©The McGraw-Hill Companies, Inc., 200 13- 21 Efficient Market Theory IPO Non-Excess Returns Average Return (%) 20 IPO Matched Stocks 15 10 First Irwin/McGraw Hill Second Third Fourth Fifth Year After Offering ©The McGraw-Hill Companies, Inc., 200 13- 22 Efficient Market Theory 1987 Stock Market Crash PV (index) pre crash Irwin/McGraw Hill Div 16.7 1193 r g 114 10 ©The McGraw-Hill Companies, Inc., 200 13- 23 Efficient Market Theory 1987 Stock Market Crash PV (index) pre crash Div 16.7 1193 r g 114 10 PV (index) post crash Div 16.7 928 r g 114 096 Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 13- 24 Lessons of Market Efficiency Markets have no memory Trust market prices Read the entrails There are no financial illusions The it yourself alternative Seen one stock, seen them all Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 13- 25 Example: How stock splits affect value 35 30 Cumulative abnormal return % 25 20 15 10 -29 30 Month relative to split Source: Fama, Fisher, Jensen & Roll Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 ... market, what is the value of the below market rate loan? NPV amount borrowed - PV of interest pmts - PV of loan repayment Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 13- Return to NPV Example... Year Trend? or yrs of the Coin Toss Game? Level 180 130 80 Month Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 13- Random Walk Theory S&P 500 Five Year Trend? or yrs of the Coin Toss... Companies, Inc., 200 13- 12 Irwin/McGraw Hill Random Walk Theory ©The McGraw-Hill Companies, Inc., 200 13- 13 Irwin/McGraw Hill Random Walk Theory ©The McGraw-Hill Companies, Inc., 200 13- 14 Irwin/McGraw