13.1 Can Financing Decisions Create Value?

Earlier parts of the book showed how to evaluate projects according to the net present value criterion. The real world is a competitive one, where projects with positive net present value are not always easy to come by. However, through hard work or through good fortune, a firm can identify winning projects. For example, to create value from capital budgeting decisions, the firm is likely to

locate an unsatisfied demand for a particular product or service;
create a barrier to make it more difficult for other firms to compete;
produce products or services at lower cost than the competition;
be the first to develop a new product.

The next five chapters concern financing decisions. Typical financing decisions include how much debt and equity to sell, what types of debt and equity to sell, and when to sell them. Just as the net present value criterion was used to evaluate capital budgeting projects, we now want to use the same criterion to evaluate financing decisions.
Though the procedure for evaluating financing decisions is identical to the procedure for evaluating projects, the results are different. It turns out that the typical firm has many more capital expenditure opportunities with positive net present values than financing opportunities with positive net present values. In fact, we later show that some plausible financial models imply that no valuable financial opportunities exist at all.
Though this dearth of profitable financing opportunities will be examined in detail later, a few remarks are in order now. We maintain that there are basically three ways to create valuable financing opportunities:

Investors lack an understanding of the risk and valuation of complex securities. Assume that a firm can raise capital either by issuing equity or by issuing a more complex security - say, a combination of shares and warrants. Suppose that, in truth, 100 shares are worth the same as 50 units of our complex security. If investors have a misguided, overly optimistic view of the complex security, perhaps the 50 units can be sold for more than the 100 shares of equity can be. Clearly, this complex security provides a valuable financing opportunity, because the firm is getting more than fair value for it.
Financial managers try to package securities to receive the greatest value. Many have argued that the global credit crisis in 2007 and 2008 was caused by investors (including financial institutions) not understanding how to quantify the risk and value of the complex securities that banks issued on the back of subprime mortgage loans.
However, the theory of efficient capital markets implies that investors cannot, in general, be easily fooled. It says that all securities are appropriately priced at all times, implying that the market as a whole is shrewd indeed. In our example, 50 units of the complex security would sell for the same price as 100 shares of equity. Thus corporate managers cannot attempt to create value by fooling investors. Instead, managers must create value in other ways.

Reduce costs or increase subsidies. We show later that certain forms of financing have greater tax advantages than other forms. Clearly, a firm packaging securities to minimize taxes can increase firm value. In addition, any financing technique involves other costs. For example, investment bankers, lawyers and accountants must be paid. A firm packaging securities to minimize these costs can also increase its value.

EXAMPLE 13.1

Valuing Financial Subsidies

Suppose Salamanca Electronics Company is thinking about relocating its plant to Mexico, where labour costs are lower. In the hope that it can stay in Salamanca, the company has submitted an application to the Castille y Leon region to issue €2 million in five-year, tax-exempt industrial bonds. The coupon rate on industrial revenue bonds in the Castille y Leon region is currently 5 per cent. This is an attractive rate, because the normal cost of debt capital for Salamanca Electronics Company is 10 per cent. What is the NPV of this potential financing transaction?
If the application is accepted and the industrial revenue bonds are issued by the Salamanca Electronics Company, the NPV (ignoring corporate taxes) is

This transaction has a positive NPV. The Salamanca Electronics Company obtains subsidized financing where the value of the subsidy is €379,079. Note that we used the normal cost of debt capital, 10 per cent, to discount the cash flows, because this is the rate that accurately reflects the cost of debt for securities of similar risk in the markets.

Create a new security. In recent decades there has been a massive surge in financial innovation. Though the advantage of each instrument is different, one general theme is that new complex securities cannot easily be duplicated by combinations of existing securities. Thus a previously unsatisfied clientele may pay extra for a specialized security catering to its needs. For example, puttable bonds let the purchaser sell the bond at a fixed price back to the firm. This innovation creates a price floor, allowing the investor to reduce his or her downside risk. Perhaps risk-averse investors or investors with little knowledge of the bond market would find this feature particularly attractive.
Corporations gain by issuing these unique securities at high prices. However, the value captured by the innovator may well be small in the long run, because the innovator usually cannot patent or copyright an idea. Soon many firms are issuing securities of the same kind, forcing prices down as a result.
It is now extremely likely that the era of complex securities has come to an end, at least for the foreseeable future. The collapse of banks such as Washington Mutual (WaMu), Lehman Brothers, Bear Stearns, Northern Rock, HBOS, Bradford & Bingley, and other casualties of 2008 was initially caused by the whole banking sector embracing complex securities to offset the risk of speculative lending policies. Post-global credit crunch will most likely see a return to the old days of basic equity and debt instruments as the financing securities of choice for most firms.

13.2 A Description of Efficient Capital Markets

An efficient capital market is one in which share prices fully reflect available information. To illustrate how an efficient market works, suppose F-stop Camera Corporation (FCC) is attempting to develop a camera that will double the speed of the auto-focusing system now available. FCC believes this research has positive NPV.
Now consider a share of equity in FCC. What determines the willingness of investors to hold shares of FCC at a particular price? One important factor is the probability that FCC will be the first company to develop the new auto-focusing system. In an efficient market, we would expect the price of the shares of FCC to increase if this probability increases.
Suppose FCC hires a well-known engineer to develop the new auto-focusing system. In an efficient market, what will happen to FCC’s share price when this is announced? If the well-known scientist is paid a salary that fully reflects his or her contribution to the firm, the share price will not necessarily change. Suppose instead that hiring the scientist is a positive NPV transaction. In this case, the share price of FCC will increase because the firm can pay the scientist a salary below his or her true value to the company.
When will the increase in the share price of FCC occur? Assume that the hiring announcement is made in a press release on Wednesday morning. In an efficient market, the FCC share price will immediately adjust to this new information. Investors should not be able to buy the shares on Wednesday afternoon and make a profit on Thursday. This would imply that it took the equity market a day to realize the implication of the FCC press release. The efficient market hypothesis predicts that the FCC share price on Wednesday afternoon will already reflect the information contained in the Wednesday morning press release.
The efficient market hypothesis (EMH) has implications for investors and for firms:

Because information is reflected in prices immediately, investors should only expect to obtain a normal rate of return. Awareness of information when it is released does an investor no good. The price adjusts before the investor has time to trade on it.
Firms should expect to receive fair value for securities that they sell. Fair means that the price they receive from issuing securities is the present value. Thus valuable financing opportunities that arise from fooling investors are unavailable in efficient capital markets.

Figure 13.1 presents several possible adjustments in equity prices. The solid line represents the path taken by the security in an efficient market. In this case the price adjusts immediately to the new information, with no further price changes. The dotted line depicts a slow reaction. Here it takes the market 30 days to fully absorb the information. Finally, the broken line illustrates an overreaction and subsequent correction back to the true price. The broken line and the dotted line show the paths that the share price might take in an inefficient market. If the share price takes several days to adjust, trading profits would be available to investors who suitably timed their purchases and sales.

Figure 13.1	Reaction of share price to new information in efficient and inefficient markets

Foundations of Market Efficiency

Figure 13.1 shows the consequences of market efficiency. But what are the conditions that cause market efficiency? Andrei Shleifer argues that there are three conditions, any one of which will lead to efficiency:¹ (a) rationality, (b) independent deviations from rationality, and (c) arbitrage. A discussion of these conditions follows.
Rationality Imagine that all investors are rational. When new information is released in the marketplace, all investors will adjust their estimates of share prices in a rational way. In our example, investors will use the information in FCC’s press release, in conjunction with existing information about the firm, to determine the NPV of FCC’s new venture. If the information in the press release implies that the NPV of the venture is £10 million and there are 2 million shares, investors will calculate that the NPV is £5 per share. While FCC’s old share price might be, say, £40, no one would now transact at that price. Anyone interested in selling would sell only at a price of at least £45 (= £40 + £5). Anyone interested in buying would now be willing to pay up to £45. In other words, the price would rise by £5. And the price would rise immediately, because rational investors would see no reason to wait before trading at the new price.
Of course, we all know times when family members, friends and, yes, even we seem to behave less than perfectly rationally. Thus perhaps it is too much to ask that all investors behave rationally. But the market will still be efficient if the following scenario holds.
Independent Deviations from Rationality Suppose that FCC’s press release is not all that clear. How many new cameras are likely to be sold? At what price? What is the likely cost per camera? Will other camera companies be able to develop competing products? How long is this likely to take? If these and other questions cannot be answered easily, it will be difficult to estimate NPV.
Now imagine that, with so many questions going unanswered, many investors do not think clearly. Some investors might get caught up in the romance of a new product, hoping for and ultimately believing in sales projections well above what is rational. They would overpay for new shares. And if they needed to sell shares (perhaps to finance current consumption), they would do so only at a high price. If these individuals dominate the market, the share price would probably rise beyond what market efficiency would predict.
However, because of emotional resistance, investors could just as easily react to new information in a pessimistic manner. After all, business historians tell us that investors were initially quite sceptical about the benefits of the telephone, the copier, the automobile, and the motion picture. Certainly, they could be overly sceptical about this new camera. If investors were primarily of this type, the share price would be likely to rise less than market efficiency would predict.
But suppose that about as many individuals were irrationally optimistic as were irrationally pessimistic. Prices would be likely to rise in a manner consistent with market efficiency, even though most investors would be classified as less than fully rational. Thus market efficiency does not require rational individuals - only countervailing irrationalities.
However, this assumption of offsetting irrationalities at all times may be unrealistic. Perhaps at certain times most investors are swept away by excessive optimism and at other times are caught in the throes of extreme pessimism. But even here there is an assumption that will produce efficiency.
Arbitrage Imagine a world with two types of individual: the irrational amateur and the rational professional. The amateurs get caught up in their emotions, at times believing irrationally that an equity is undervalued and at other times believing the opposite. If the passions of the different amateurs do not cancel each other out, these amateurs, by themselves, would tend to carry shares either above or below their efficient prices.
Now let’s bring in the professionals. Suppose professionals go about their business methodically and rationally. They study companies thoroughly, they evaluate the evidence objectively, they estimate share prices coldly and clearly, and they act accordingly. If an equity is underpriced, they would buy it. If it is overpriced, they would sell it. And their confidence would probably be greater than that of the amateurs. Whereas an amateur might risk only a small sum, these professionals might risk large ones, knowing as they do that the security is mispriced. Furthermore, they would be willing to rearrange their entire portfolio in search of a profit. Arbitrage is the word that comes to mind here, because arbitrage generates profit from the simultaneous purchase and sale of different, but substitute, securities. If the arbitrage of professionals dominates the speculation of amateurs, markets would still be efficient.

13.3 The Different Types of Efficiency

In our previous discussion we assumed that the market responds immediately to all available information. In actuality, certain information may affect share prices more quickly than other information. To handle differential response rates, researchers separate information into different types. The most common classification system identifies three types: information about past prices, publicly available information, and all information. The effect of these three information sets on prices is examined next.

The Weak Form

Imagine a trading strategy that recommends buying a share after it has gone up three days in a row and recommends selling a share after it has gone down three days in a row. This strategy uses information based only on past prices. It does not use any other information, such as earnings, forecasts, merger announcements, or money supply figures. A capital market is said to be weakly efficient or to satisfy weak form efficiency if it fully incorporates the information on past share prices. Thus the preceding strategy would not be able to generate profits if weak form efficiency holds.
Often weak form efficiency is represented mathematically as

Equation 13.1 states that the price today is equal to the sum of the last observed price plus the expected return on the equity (in pounds or euros) plus a random component occurring over the interval. The last observed price could have occurred yesterday, last week, or last month, depending on the sampling interval. The expected return is a function of a security’s risk, and would be based on the models of risk and return in previous chapters. The random component is due to new information about the company. It could be either positive or negative, and has an expectation of zero. The random component in any period is unrelated to the random component in any past period. Hence this component is not predictable from past prices. If share prices follow Eq. 13.1 they are said to follow a random walk.²
Weak form efficiency is about the weakest type of efficiency that we would expect a financial market to display, because historical price information is the easiest kind of information about a company’s equity to acquire. If it were possible to make extraordinary profits simply by finding patterns in share price movements, everyone would do it, and any profits would disappear in the scramble.
This effect of competition can be seen in Fig. 13.2. Suppose a company’s share price displays a cyclical pattern, as indicated by the wavy curve. Shrewd investors would buy at the low points, forcing those prices up. Conversely, they would sell at the high points, forcing prices down. Via competition, cyclical regularities would be eliminated, leaving only random fluctuations.

Figure 13.2	Investor behaviour tends to eliminate cyclical patterns

The Semi-Strong and Strong Forms

If weak form efficiency is controversial, even more contentious are the two stronger types of efficiency, semi-strong form efficiency and strong form efficiency. A market is semi-strong form efficient if prices reflect (incorporate) all publicly available information, including information such as published accounting statements for the firm as well as historical price information. A market is strong form efficient if prices reflect all information, public or private.
The information set of past prices is a subset of the information set of publicly available information, which in turn is a subset of all information. This is shown in Fig. 13.3. Thus strong form efficiency implies semi-strong form efficiency, and semi-strong form efficiency implies weak form efficiency. The distinction between semi-strong form efficiency and weak form efficiency is that semi-strong form efficiency requires not only that the market be efficient with respect to historical price information, but that all of the information available to the public be reflected in prices.

Figure 13.3	Relationship among three different information sets

To illustrate the different forms of efficiency, imagine an investor who always sold a particular equity after its price had risen. A market that was only weak form efficient and not semi-strong form efficient would still prevent such a strategy from generating positive profits. According to weak form efficiency, a recent price rise does not imply that the equity is overvalued.
Now consider a firm reporting increased earnings. An individual might consider investing in the company’s shares after reading the news release providing this information. However, if the market is semi-strong form efficient, the price should rise immediately upon the news release. Thus the investor would end up paying the higher price, eliminating all chance for profit.
At the furthest end of the spectrum is strong form efficiency. This form says that anything that is pertinent to the value of the security and that is known to at least one investor is, in fact, fully incorporated into the share price. A strict believer in strong form efficiency would deny that an insider who knew whether a company mining operation had struck gold could profit from that information. Such a devotee of the strong form efficient market hypothesis might argue that as soon as the insider tried to trade on his or her information, the market would recognize what was happening, and the price would shoot up before he or she could buy any shares. Alternatively, believers in strong form efficiency argue that there are no secrets, and as soon as the gold is discovered, the secret gets out.
One reason to expect that markets are weak form efficient is that it is so cheap and easy to find patterns in share prices. Anyone who can program a computer and knows a little bit of statistics can search for such patterns. It stands to reason that if there were such patterns, people would find and exploit them, in the process causing them to disappear.
Semi-strong form efficiency, though, implies more sophisticated investors than does weak form efficiency. An investor must be skilled in accounting, finance and statistics, and steeped in the idiosyncrasies of individual industries and companies. Furthermore, to acquire and use such skills requires talent, ability and time. In the jargon of the economist, such an effort is costly, and the ability to be successful at it is probably in scarce supply.
As for strong form efficiency, this is just further down the road than semi-strong form efficiency. It is difficult to believe that the market is so efficient that someone with valuable inside information cannot prosper from it. And empirical evidence tends to be unfavourable to this form of market efficiency.

Some Common Misconceptions about the Efficient Market Hypothesis

No idea in finance has attracted as much attention as that of efficient markets, and not all of the attention has been flattering. To a certain extent this is because much of the criticism has been based on a misunderstanding of what the hypothesis does and does not say. We illustrate three misconceptions next.
The Efficacy of Dart Throwing When the notion of market efficiency was first publicized and debated in the popular financial press, it was often characterized by the following quote: ‘. . . throwing darts at the financial page will produce a portfolio that can be expected to do as well as any managed by professional security analysts.’³ This is almost, but not quite, true.
All the efficient market hypothesis really says is that, on average, the manager will not be able to achieve an abnormal or excess return. The excess return is defined with respect to some benchmark expected return, such as that from the security market line of Chapter 11 (SML). The investor must still decide how risky a portfolio he or she wants. In addition, a random dart thrower might wind up with all of the darts sticking into one or two high-risk equities that deal in genetic engineering. Would you really want all of your equity investments in two such equities?
The failure to understand this has often led to confusion about market efficiency. For example, sometimes it is wrongly argued that market efficiency means that it does not matter what you do, because the efficiency of the market will protect the unwary. However, someone once remarked, ‘The efficient market protects the sheep from the wolves, but nothing can protect the sheep from themselves.’
What efficiency does say is that the price that a firm obtains when it sells a share of its equity is a fair price in the sense that it reflects the value of that equity given the information that is available about it. Shareholders need not worry that they are paying too much for an equity with a low dividend, or some other characteristic, because the market has already incorporated it into the price. However, investors still have to worry about such things as their level of risk exposure and their degree of diversification.
Price Fluctuations Much of the public is sceptical of efficiency, because share prices fluctuate from day to day. However, daily price movement is in no way inconsistent with efficiency; an equity in an efficient market adjusts to new information by changing price. A great deal of new information comes into the stock market each day. In fact, the absence of daily price movements in a changing world might suggest an inefficiency.
Shareholder Disinterest Many laypeople are sceptical that the market price can be efficient if only a fraction of the outstanding shares changes hands on any given day. However, the number of traders in a company’s shares on a given day is generally far less than the number of people following the shares. This is true because an individual will trade only when his appraisal of the value of the equity differs enough from the market price to justify incurring brokerage commissions and other transaction costs. Furthermore, even if the number of traders following an equity is small relative to the number of outstanding shareholders, the company’s shares can be expected to be efficiently priced as long as a number of interested traders use the publicly available information. That is, the share price can reflect the available information even if many shareholders never follow the company and are not considering trading in the near future.

13.3 The Different Types of Efficiency

The Weak Form

Figure 13.2	Investor behaviour tends to eliminate cyclical patterns

The Semi-Strong and Strong Forms

Figure 13.3	Relationship among three different information sets

Some Common Misconceptions about the Efficient Market Hypothesis

Figure 13.4	Simulated and actual share price movements

Next consider the graph on the right, which tracks actual movements in The Gap’s share price. This graph may look quite non-random to some, suggesting weak form inefficiency. However, it also bears a close visual resemblance to the simulated series, and statistical tests indicate that it indeed behaves like a purely random series. Thus, in our opinion, people claiming to see patterns in historical share price data are probably seeing optical illusions.

The Semi-Strong Form

The semi-strong form of the efficient market hypothesis implies that prices should reflect all publicly available information. We present two types of tests of this form.
Event Studies The abnormal return (AR) on a given security for a particular day can be calculated by subtracting the market’s return on the same day (R_m) - as measured by a broad-based index such as the FTSE. All Share or Euro Stoxx 50 index - from the actual return (R) on the equity for that day.⁴ We write this algebraically as
AR = R - R_m
The following system will help us understand tests of the semi-strong form:

The arrows indicate that the abnormal return in any time period is related only to the information released during that period.
According to the efficient market hypothesis, a company’s abnormal return at time t, AR_t, should reflect the release of information at the same time, t. Any information released before then should have no effect on abnormal returns in this period because all of its influence should have been felt before. In other words, an efficient market would already have incorporated previous information into prices. Because a company’s share price return today cannot depend on what the market does not yet know, information that will be known only in the future cannot influence the company’s return either. Hence the arrows point in the direction that is shown, with information in any period affecting only that period’s abnormal return. Event studies are statistical studies that examine whether the arrows are as shown or whether the release of information influences returns on other days.
These studies also speak of cumulative abnormal returns (CARs), as well as abnormal returns (ARs). As an example, consider a firm with ARs of 1 per cent, -3 per cent and 6 per cent for dates -1, 0 and 1, respectively, relative to a corporate announcement. The CARs for dates -1, 0 and 1 would be 1 per cent, -2 per cent [= 1 per cent + (-3 per cent)], and 4 per cent [= 1 per cent + (-3 per cent) + 6 per cent], respectively.
As an example, consider the study by Szewczyk, Tsetsekos and Zantout⁵ on dividend omissions. Fig. 13.5 shows the plot of CARs for a sample of companies announcing dividend omissions. Because dividend omissions are generally considered to be bad events, we would expect abnormal returns to be negative around the time of the announcements. They are, as evidenced by a drop in the CAR on both the day before the announcement (day -1) and the day of the announcement (day 0). However, note that there is virtually no movement in the CARs in the days following the announcement. This implies that the bad news is fully incorporated into the stock price by the announcement day, a result consistent with market efficiency.

Figure 13.5	Cumulative abnormal returns for companies announcing dividend omissions

Over the years this type of methodology has been applied to many events. Announcements of dividends, earnings, mergers, capital expenditures, and new issues of equity are a few examples of the vast literature in the area. The early event study tests generally supported the view that the market is semi-strong form (and therefore also weak form) efficient. However, a number of more recent studies present evidence that the market does not impound all relevant information immediately. Some conclude from this that the market is not efficient. Others argue that this conclusion is unwarranted, given statistical and methodological problems in the studies. This issue will be addressed in more detail later in the chapter.
The Record of Mutual Funds If the market is efficient in the semi-strong form, then no matter what publicly available information mutual fund managers rely on to pick equities, their average returns should be the same as those of the average investor in the market as a whole. We can test efficiency, then, by comparing the performance of these professionals with that of a market index.
Consider Fig. 13.6, which presents the performance of various types of US mutual fund relative to the stock market as a whole. The far left of the figure shows that the universe of all funds covered in the study underperforms the market by 2.13 per cent per year after an appropriate adjustment for risk. Thus, rather than outperforming the market, the evidence shows underperformance. This underperformance holds for a number of types of fund as well. Returns in this study are net of fees, expenses and commissions, so fund returns would be higher if these costs were added back. However, the study shows no evidence that funds, as a whole, are beating the market.

Figure 13.6	Annual return performance of different types of US mutual fund relative to a broad-based market index (1963-1998) (Performance is relative to the market model.)

European evidence is more positive regarding the investment decisions of fund managers. Otten and Bams (2002) examined the performance of funds in five European countries (UK, France, Italy, the Netherlands, and Germany) and found positive performance for some countries, before and after expenses are taken into account. Table 13.2 summarizes the main findings of the paper. In all cases, with the exception of Germany, mutual funds outperformed the market before fees were taken into account. Even once the returns have been calculated net of fees, the UK and Netherlands mutual funds return significantly positive performance.

Table 13.2	European fund performance after and before management fees 1991-1998

By and large, mutual fund managers rely on publicly available information. Thus the finding that they do not outperform market indexes is consistent with semi-strong form and weak form efficiency. Obviously the European evidence casts some doubt on this finding but, in general, research has shown that mutual funds do not consistently outperform the market.
Does the evidence imply that, in general, mutual funds are bad investments for indi-viduals? Not necessarily. Though many funds fail to achieve better returns than some indices of the market, they do permit the investor to buy a portfolio of many securities (the phrase ‘a well-diversified portfolio’ is often used). They might also provide a variety of services, such as keeping custody and records of all the company’s shares.

The Strong Form

Even the strongest adherents to the efficient market hypothesis would not be surprised to find that markets are inefficient in the strong form. After all, if an individual has information that no one else has, it is likely that she can profit from it.
One group of studies of strong form efficiency investigates insider trading. Insiders in firms have access to information that is not generally available. But if the strong form of the efficient market hypothesis holds, they should not be able to profit by trading on their information. Most government agencies require insiders in companies to reveal any trading they might do in their own company’s securities. By examining the record of such trades, we can see whether they made abnormal returns.
Figure 13.7 shows the cumulative abnormal returns that UK directors earned from their trading between 1994 and 2005. It is clear that there is a strong market reaction in the days after insider trading, and that their trades were abnormally profitable. This view is supported using data in other countries. Given that it seems one can make abnormal profits from private information, strong form efficiency does not seem to be substantiated by the evidence.

Figure 13.7	Cumulative abnormal returns from UK director trading

13.5 The Behavioural Challenge to Market Efficiency

In Section 13.2 we presented Prof. Shleifer’s three conditions, any one of which will lead to market efficiency. In that section we made a case that at least one of the conditions is likely to hold in the real world. However, there is definitely disagreement here. Many members of the academic community (including Prof. Shleifer) argue that none of the three conditions is likely to hold in reality. This point of view is based on what is called behavioural finance. Let us examine the behavioural view of each of these three conditions.

Rationality

Are people really rational? Not always. Just travel to any casino to see people gambling, sometimes with large sums of money. The casino’s take implies a negative expected return for the gambler. Because gambling is risky and has a negative expected return, it can never be on the efficient frontier of our Chapter 10. In addition, gamblers will often bet on black at a roulette table after black has occurred a number of consecutive times, thinking that the run will continue. This strategy is faulty, because roulette tables have no memory.
But, of course, gambling is only a sideshow as far as finance is concerned. Do we see irrationality in financial markets as well? The answer may well be yes. Many investors do not achieve the degree of diversification that they should. Others trade frequently, generating both commissions and taxes. In fact, taxes can be handled optimally by selling losers and holding onto winners. Although some individuals invest with tax minimization in mind, plenty of them do just the opposite. Many are more likely to sell their winners than their losers, a strategy leading to high tax payments.⁶ The behavioural view is not that all investors are irrational. Rather, it is that some, perhaps many, investors are.

Independent Deviations from Rationality

Are deviations from rationality generally random, and thereby likely to cancel out in a whole population of investors? On the contrary, psychologists have long argued that people deviate from rationality in accordance with a number of basic principles. Not all of these principles have an application to finance and market efficiency, but at least two seem to do so.
The first principle, called representativeness, can be explained with the gambling example just used. The gambler believing a run of black will continue is in error because the probability of a black spin is still only about 50 per cent. Gamblers behaving in this way exhibit the psychological trait of representativeness. That is, they draw conclusions from insufficient data. In other words, the gambler believes the small sample he observed is more representative of the population than it really is.
How is this related to finance? Perhaps a market dominated by representativeness leads to bubbles. People see a sector of the market - for example, subprime mortgages - having a short history of high revenue growth and extrapolate that it will continue for ever. When the growth inevitably stalls, prices have nowhere to go but down.
The second principle is conservatism, which means that people are too slow in adjusting their beliefs to new information. Suppose that your goal since childhood was to become a dentist. Perhaps you came from a family of dentists, perhaps you liked the security and relatively high income that comes with that profession, or perhaps teeth always fascinated you. As things stand now, you could probably look forward to a long and productive career in that occupation. However, suppose a new drug was developed that would prevent tooth decay. That drug would clearly reduce the demand for dentists. How quickly would you realize the implications as stated here? If you were emotionally attached to dentistry, you might adjust your beliefs slowly. Family and friends could tell you to switch out of dental courses at university, but you just might not be psychologically ready to do that. Instead, you might cling to your rosy view of dentistry’s future.
Perhaps there is a relationship to finance here. For example, many studies report that prices seem to adjust slowly to the information contained in earnings announcements.⁷ Could it be that, because of conservatism, investors are slow in adjusting their beliefs to new information? More will be said about this in the next section.

Arbitrage

In Section 13.2 we suggested that professional investors, knowing that securities are mispriced, could buy the underpriced ones while selling correctly priced (or even overpriced) substitutes. This might undo any mispricing caused by emotional amateurs.
Trading of this sort is likely to be more risky than it appears at first glance. Suppose professionals generally believed that the shares of the copper mining firm Vedanta Resources plc were underpriced. They would buy them while selling their holdings in other mining firms - say, Anglo American and Rio Tinto plc. However, if amateurs were taking opposite positions, prices would adjust to correct levels only if the positions of amateurs were small relative to those of the professionals. In a world of many amateurs, a few professionals would have to take big positions to bring prices into line, perhaps even engaging heavily in short selling. Buying large amounts of one company’s shares and short-selling large amounts of other company’s shares is quite risky, even if the two shares are in the same industry. Here, unanticipated bad news about Vedanta Resources and unanticipated good news about the other two companies would cause the professionals to register large losses.
In addition, if amateurs mispriced Vedanta Resources today, what is to prevent Vedanta from being even more mispriced tomorrow? This risk of further mispricing, even in the presence of no new information, may also cause professionals to cut back their arbitrage positions. As an example, imagine a shrewd professional who believed banking stocks were overpriced in early 2007. Had he bet on a decline at that time, he would have lost in the near term: prices rose through the first six months of 2007. Yet he would have eventually made money, because prices later fell. However, near-term risk may reduce the size of arbitrage strategies.
In conclusion, the arguments presented here suggest that the theoretical underpinnings of the efficient capital markets hypothesis, presented in Section 13.2, might not hold in reality. That is, investors may be irrational, irrationality may be related across investors rather than cancelling out across investors, and arbitrage strategies may involve too much risk to eliminate market efficiencies.

13.6 Empirical Challenges to Market Efficiency

Section 13.4 presented empirical evidence supportive of market efficiency. We now present evidence challenging this hypothesis. (Adherents of market efficiency generally refer to results of this type as anomalies.)

Limits to Arbitrage

Royal Dutch Petroleum and Shell Transport merged their interests in 1907, with all subsequent cash flows being split on a 60-40 per cent basis between the two companies. However, both companies continued to be publicly traded. You might imagine that the market value of Royal Dutch would always be 1.5 (= 60/40) times that of Shell. That is, if Royal Dutch ever became overpriced, rational investors would buy Shell instead of Royal Dutch. If Royal Dutch were underpriced, investors would buy Royal Dutch. In addition, arbitrageurs would go further by buying the underpriced security and selling the overpriced security short.
However, Fig. 13.8 shows that Royal Dutch and Shell have rarely traded at parity (i.e. 60/40) over the 1962 to 2004 period. Why would these deviations occur? As stated in the previous section, behavioural finance suggests that there are limits to arbitrage. That is, an investor buy-ing the overpriced asset and selling the underpriced asset does not have a sure thing. Deviations from parity could actually increase in the short run, implying losses for the arbitrageur. The well-known statement ‘Markets can stay irrational longer than you can stay solvent’, attributed to John Maynard Keynes, applies here. Thus risk considerations may force arbitrageurs to take positions that are too small to move prices back to parity.

Figure 13.8	Deviations from parity of the ratio of the market value of Royal Dutch to the market value of Shell

Academics have documented a number of these deviations from parity. Froot and Dabora show similar results for both the twin companies of Unilever N.V. and Unilever plc, and for two classes of SmithKline Beecham shares.⁸ Lamont and Thaler present similar findings for 3Com and its subsidiary Palm Inc.⁹ Other researchers find price behaviour in closed-end mutual funds suggestive of parity deviations.

Earnings Surprises

Common sense suggests that prices should rise when earnings are reported to be higher than expected, and should fall when the reverse occurs. However, market efficiency implies that prices will adjust immediately to the announcement, while behavioural finance would predict another pattern. Kolasinski and Li rank US companies by the extent of their earnings surprise - that is, the difference between current quarterly earnings and quarterly earnings four quarters ago, divided by the current share price.¹⁰ They form a portfolio of companies with the most extreme positive surprises and another portfolio of companies with the most extreme negative surprises. Figure 13.9 shows returns from buying the two portfolios, net of the return on the overall market. As can be seen, prices adjust slowly to the earnings announcements, with the portfolio with the positive surprises outperforming the portfolio with the negative surprises over both the next month and the next six months. Many other researchers obtain similar results.

Figure 13.9	Returns to two investment strategies based on earnings surprise

Why do prices adjust slowly? Behavioural finance suggests that investors exhibit conservatism because they are slow to adjust to the information contained in the announcements.

Size

In 1981 two important papers presented evidence that, in the United States, the returns on equities with small market capitalizations were greater than the returns on equities with large market capitalizations over most of the 20th century.¹¹ The studies have since been replicated over different periods and in different countries. For example, Fig. 13.10 shows average returns over the period from 1963 to 1995 for five portfolios of US equities ranked by size. As can be seen, the average return on small stocks is quite a bit higher than the average return on large equities. Although much of the differential performance is merely compensation for the extra risk of small firms, researchers have generally argued that not all of it can be explained by risk differences. In addition, Donald Keim presented evidence that most of the difference in performance occurs in the month of January.¹²

Figure 13.10	Annual share price returns on portfolios sorted by size (market capitalization)

Value versus Growth

A number of papers have argued that equities with high book-value-to-share-price ratios and/or high earnings-to-price ratios (generally called value stocks) outperform equities with low ratios (growth stocks). For example, Fama and French find that for 12 of 13 major international stock markets the average return on equities with high book-value-to-share-price ratios is above the average return on equities with low book-value-to-share-price ratios.¹³ Figure 13.11 shows the returns for a number of European countries for the period 1997 to 2006. In every country, with the exception of Germany and Switzerland, value stocks outperformed growth stocks.

Figure 13.11	Annual percentage returns on low book-to-price firms and high book-to-price firms in selected countries for the period 1997-2006

Because the return difference is so large, and because these ratios can be obtained so easily for individual companies, the results may constitute strong evidence against market efficiency. However, a number of papers suggest that the unusual returns are due to biases in commercial databases or to differences in risk, not to a true inefficiency.¹⁴ Because the debate revolves around arcane statistical issues, we shall not pursue the issue further. However, it is safe to say that no conclusion is warranted at this time. As with so many other topics in finance and economics, further research is needed.

13.7 Reviewing the Differences

It is fair to say that the controversy over efficient capital markets has not yet been resolved. Rather, academic financial economists have sorted themselves into three camps, with some adhering to market efficiency, some believing in behavioural finance, and others (perhaps the majority) not yet convinced that either side has won the argument. This state of affairs is cer-tainly different from, say, 20 years ago, when market efficiency went unchallenged. In addition, the controversy here is perhaps the most contentious of any area of financial economics.
Because of the controversy, it does not appear that our textbook, or any textbook, can easily resolve the differing points of view. However, we can illustrate the differences between the camps by relating the two psychological principles mentioned earlier, representativeness and conservatism, to share price returns.

Representativeness

This principle implies overweighting the results of small samples, as with the gambler who thinks a few consecutive spins of black on the roulette wheel make black a more likely outcome than red on the next spin. Financial economists have argued that representativeness leads to overreaction in share price returns. We mentioned earlier that financial bubbles are likely overreactions to news. Internet companies showed great revenue growth for a short time in the late 1990s, causing many to believe that this growth would continue indefinitely. Share prices rose (too much) at this point. Similarly, most people in the banking sector thought that subprime mortgages would provide strong returns at little risk. It was only when these loans started to go bad in 2008, and banks such as Washington Mutual, Lehmann Brothers, Bear Stearns, Northern Rock, Royal Bank of Scotland and HBOS got into serious financial distress, that they realized how wrong they were. In both cases, when investors realized that they were wrong, prices plummeted.

Conservatism

This principle states that individuals adjust their beliefs too slowly to new information. A market composed of this type of investor would probably lead to share prices that underreact in the presence of new information. The example concerning earnings surprises may illustrate this underreaction. Prices rose slowly following announcements of positive earnings surprises. Announcements of negative surprises had a similar, but opposite, reaction.
The global credit crisis of 2008 gives us another good example of conservatism in financial markets. When the British bank Northern Rock was nationalized in the early part of the year, investors thought or hoped that it would only be that bank which was affected. Then Bear Stearns, the US investment bank, had to be bought over by JP Morgan Chase in May 2008, and although investors were shaken they still clung to hopes that the credit crisis was nearly over. Fast forward to September 2008 and the banking sector had ground to a halt. In the space of one week, Lehmann Brothers went bankrupt in the world’s largest-ever bankruptcy. HBOS, Britain’s largest mortgage lender, had to be bought over by Lloyds TSB after its share price collapsed. The US and UK governments temporarily halted the practice of short selling, and the Russian stock markets had to close for a day because prices became too volatile. With hindsight, it is easy to see that the credit crisis had only really started when Northern Rock was nationalized. It could even be argued that if investors had acted rationally three years earlier, the disaster that hit the world’s economies might have been averted.

The Academic Viewpoints

The academic camps have different views of these results. The efficient market believers stress that representativeness and conservatism have opposite implications for share prices. Which principle, they ask, should dominate in any particular situation? In other words, why should investors overreact to news about Internet stocks but underreact to banking stocks? Proponents of market efficiency say that unless behaviourists can answer these two questions satisfactorily, we should not reject market efficiency in favour of behavioural finance. In addition, Eugene Fama¹⁵ reviewed the academic studies on anomalies, finding that about half of them show overreaction and half show underreaction. He concluded that this evidence is consistent with the market efficiency hypothesis that anomalies are chance events.
Adherents of behavioural finance see things a little differently. First, they point out that, as discussed in Section 13.5, the three theoretical foundations of market efficiency appear to be violated in the real world. Second, there are simply too many anomalies, with a number of them being replicated in out-of-sample tests. This argues against anomalies being mere chance events. Finally, though the field has not yet determined why either overreaction or underreaction should dominate in a particular situation, much progress has already been made in a short time.¹⁶

13.8 Implications for Corporate Finance

So far this chapter has examined both theoretical arguments and empirical evidence concerning efficient markets. We now ask whether market efficiency has any relevance for corporate financial managers. The answer is that it does. Next we consider four implications of efficiency for managers.

Accounting Choices, Financial Choices, and Market Efficiency

The accounting profession provides firms with a significant amount of leeway in their reporting practices. Managers clearly prefer high share prices to low share prices. Should managers use the leeway in accounting choices to report the highest possible income? Not necessarily. That is, accounting choice should not affect share price if two conditions hold. First, enough information must be provided in the annual report so that financial analysts can construct earnings under the alternative accounting methods. This appears to be the case for many, though not necessarily all, accounting choices. Second, the market must be efficient in the semi-strong form. In other words, the market must use all of this accounting information appropriately in determining the market price.
Of course, the issue of whether accounting choice affects share price is ultimately an empir-ical matter. A number of academic papers have addressed this issue. Kaplan and Roll found that the switch from accelerated to straight-line depreciation did not affect share prices.¹⁷
Several other accounting procedures have been studied. Hong, Kaplan and Mandelker found no evidence that the stock market was affected by the artificially higher earnings reported using the pooling method, compared with the purchase method, for reporting mergers and acquisitions.¹⁸ In summary, empirical evidence suggests that accounting changes do not fool the market. Therefore the evidence does not suggest that managers can boost share price through accounting practices. In other words, the market appears efficient enough to see through different accounting choices.
One caveat is called for here. Our discussion specifically assumed that ‘financial analysts can construct earnings under the alternative accounting methods’. However, companies such as Enron, WorldCom, Global Crossing, Parmalat and Xerox simply reported fraudulent numbers in recent years. There was no way for financial analysts to construct alternative earnings numbers, because these analysts were unaware how the reported numbers were determined. So it was not surprising that the share prices of these companies initially rose well above fair value. Yes, managers can boost prices in this way - as long as they are willing to serve time in prison once they are caught!

The Timing Decision

Imagine a firm whose managers are contemplating the date to issue equity. This decision is frequently called the timing decision. If managers believe that their equity is overpriced, they are likely to issue shares immediately. Here, they are creating value for their current shareholders because they are selling shares for more than they are worth. Conversely, if the managers believe that their equity is underpriced, they are more likely to wait, hoping that the equity price will eventually rise to its true value.
However, if markets are efficient, securities are always correctly priced. Efficiency implies that equity is sold for its true worth, so the timing decision becomes unimportant. Figure 13.13 shows three possible share price adjustments to the issuance of new equity.

Figure 13.13	Three share price adjustments after issuing equity

Ritter presents evidence that annual equity returns over the five years following an initial public offering (IPO) are about 2 per cent less for the issuing company than the returns on a non-issuing company of similar book-to-market ratio.¹⁹ Annual share price returns over this period following a seasoned equity offering (SEO) are between 3 per cent and 4 per cent less for the issuing company than for a comparable non-issuing company. A company’s first public offering is called an IPO and all subsequent offerings are termed SEOs. The upper half of Fig. 13.14 shows average annual returns of both IPOs and their control group, and the lower half of the figure shows average annual returns of both SEOs and their control group.

Figure 13.14	Returns on initial public offerings (IPOs) and seasoned equity offerings (SEOs) in years following issue

The evidence in Ritter’s paper suggests that corporate managers issue SEOs when the company’s equity is overpriced. In other words, managers appear to time the market successfully. The evidence that managers time their IPOs is less compelling: returns following IPOs are closer to those of their control group.
Does the ability of a corporate official to issue an SEO when the security is overpriced indicate that the market is inefficient in the semi-strong form or the strong form? The answer is actually somewhat more complex than it may first appear. On the one hand, officials are likely to have special information that the rest of us do not have, suggesting that the market need only be inefficient in the strong form. On the other hand, if the market were truly semi-strong efficient, the price would drop immediately and completely upon the announcement of an upcoming SEO. That is, rational investors would realize that equity is being issued, because corporate officials have special information that the shares are overpriced. Indeed, many empirical studies report a price drop on the announcement date. However, Fig. 13.13 shows a further price drop in the subsequent years, suggesting that the market is inefficient in the semi-strong form.
If firms can time the issuance of shares, perhaps they can also time the repurchase of shares. A firm would like to repurchase when its equity is undervalued. Ikenberry, Lakonishok and Vermaelen find that equity returns of repurchasing firms are abnormally high in the two years following repurchase, suggesting that timing is effective here.²⁰

Speculation and Efficient Markets

We normally think of individuals and financial institutions as the primary speculators in financial markets. However, industrial corporations speculate as well. For example, many companies make interest rate bets. If the managers of a firm believe that interest rates are likely to rise, they have an incentive to borrow, because the present value of the liability will fall with the rate increase. In addition, these managers will have an incentive to borrow long-term rather than short-term in order to lock in the low rates for a longer period. The thinking can get more sophisticated. Suppose that the long-term rate is already higher than the short-term rate. The manager might argue that this differential reflects the market’s view that rates will rise. However, perhaps he anticipates a rate increase even greater than what the market anticipates, as implied by an upward-sloping term structure. Again, the manager will want to borrow long-term rather than short-term.
Firms also speculate in foreign currencies. Suppose that the CFO of a multinational cor-poration based in the United Kingdom believes that the euro will decline relative to sterling. She would probably issue euro-denominated debt rather than sterling-denominated debt, because she expects the value of the foreign liability to fall. Conversely, she would issue debt domestically if she believes foreign currencies will appreciate relative to the British pound.
We are perhaps getting a little ahead of our story: the subtleties of the term structure and exchange rates are treated in other chapters, not this one. However, the big question is this: What does market efficiency have to say about such activity? The answer is clear. If financial markets are efficient, managers should not waste their time trying to forecast the movements of interest rates and foreign currencies. Their forecasts will probably be no better than chance. And they will be using up valuable executive time. This is not to say, however, that firms should flippantly pick the maturity or the denomination of their debt in a random fashion. A firm must choose these parameters carefully. However, the choice should be based on other rationales, not on an attempt to beat the market. For example, a firm with a project lasting five years might decide to issue five-year debt. A firm might issue renminbi-denominated debt because it anticipates expanding into China in a big way.
The same thinking applies to acquisitions. Many corporations buy up other firms because they think these targets are underpriced. Unfortunately, the empirical evidence suggests that the market is too efficient for this type of speculation to be profitable. And the acquirer never pays just the current market price. The bidding firm must pay a premium above market to induce a majority of shareholders of the target firm to sell their shares. However, this is not to say that firms should never be acquired. Rather, managers should consider an acquisition if there are benefits (synergies) from the union. Improved marketing, economies in production, replacement of bad management, and even tax reduction are typical synergies. These synergies are distinct from the perception that the acquired firm is underpriced.
One final point should be mentioned. We talked earlier about empirical evidence suggesting that SEOs are timed to take advantage of overpriced equity. This makes sense - managers are likely to know more about their own firms than the market does. However, while managers may have special information about their own firms, it is unlikely that they have special information about interest rates, foreign currencies, or other firms. There are simply too many participants in these markets, many of whom are devoting all of their time to forecasting. Managers typically spend most of their effort running their own firms, with only a small amount of time devoted to studying financial markets.

Information in Market Prices

The previous section argued that it is quite difficult to forecast future market prices. However, the current and past prices of any asset are known - and of great use. Consider, for example, Becher’s study of bank mergers.²¹ The author finds that share prices of acquired banks rise about 23 per cent on average upon the first announcement of a merger. This is not surprising, because companies are generally bought out at a premium above current share price. However, the same study shows that prices of acquiring banks fall almost 5 per cent on average upon the same announcement. This is pretty strong evidence that bank mergers do not benefit, and may even hurt, acquiring companies. The reason for this result is unclear, though perhaps acquirers simply overpay for acquisitions. Regardless of the reason, the implication is clear. A bank should think deeply before acquiring another bank.
Furthermore, suppose you are the CFO of a company whose share price drops much more than 5 per cent upon announcement of an acquisition. The market is telling you that the merger is bad for your firm. Serious consideration should be given to cancelling the merger, even if, prior to the announcement, you thought the merger was a good idea.
Of course, mergers are only one type of corporate event. Managers should pay attention to the share price reaction to any of their announcements, whether it concerns a new venture, a divestiture, a restructuring, or something else.
This is not the only way in which corporations can use the information in market prices. Suppose you are on the board of directors of a company whose share price has declined precipitously since the current chief executive officer (CEO) was hired. In addition, the prices of competitors have risen over the same time. Though there may be extenuating circumstances, this can be viewed as evidence that the CEO is doing a poor job. Perhaps he should be fired. If this seems harsh, consider that Warner, Watts and Wruck find a strong negative correlation between managerial turnover and prior stock performance.²² Figure 13.15 shows that share prices fall on average about 40 per cent in price (relative to market movements) in the three years prior to the forced departure of a top manager.

Figure 13.15	Share price performance prior to forced departures of management

Market efficiency implies that share prices reflect all available information. We recommend using this information as much as possible in corporate decisions as long as the manager feels that share prices accurately reflect the true value of company equity. In most emerging-market countries stock markets may not be very efficient, and you should be careful about using available share prices. In developed economies, at least with respect to executive firings and executive compensation, it looks as if real-world corporations do pay attention to market prices. The following box summarizes some key issues in the efficient markets debate:

Efficient Market Hypothesis: A Summary

Does not say:

Prices are uncaused.
Investors are foolish and too stupid to be in the market.
All shares of equity have the same expected returns.
Investors should throw darts to select shares.
There is no upward trend in share prices.

Does say:

Prices reflect underlying value.
Financial managers cannot time equity and bond sales.
Managers cannot profitably speculate in foreign currencies.
Managers cannot boost share prices through creative accounting.

Why doesn’t everybody believe it?

There are optical illusions, mirages, and apparent patterns in charts of stock market returns.
The truth is less interesting.
There is evidence against efficiency:
1. Two different, but financially identical, classes of shares of the same firm selling at different prices.
2. Earnings surprises.
3. Small versus large company share price returns.
4. Value versus growth stocks.
5. Crashes and bubbles.

Three forms
Weak form: Current prices reflect past prices; chartism (technical analysis) is useless.
Semi-strong form: Prices reflect all public information; most financial analysis is useless.
Strong form: Prices reflect all that is knowable; nobody consistently makes superior profits.

An efficient financial market processes the information available to investors, and incorporates it into the prices of securities. Market efficiency has two general implications. First, in any given time period, an equity’s abnormal return depends on information or news received by the market in that period. Second, an investor who uses the same information as the market cannot expect to earn abnormal returns. In other words, systems for playing the market are doomed to fail.
What information does the market use to determine prices? The weak form of the efficient market hypothesis says that the market uses the history of prices, and is therefore efficient with respect to these past prices. This implies that security selection based on patterns of past share price movements is no better than random selection.
The semi-strong form states that the market uses all publicly available information in setting prices.
Strong form efficiency states that the market uses all of the information that anybody knows about equities, even inside information.
Much evidence from different financial markets supports weak form and semi-strong form efficiency but not strong form efficiency.
Behavioural finance states that the market is not efficient. Adherents argue that:
1. investors are not rational;
2. deviations from rationality are similar across investors;
3. arbitrage, being costly, will not eliminate inefficiencies.
Behaviourists point to many studies, including those showing that small company shares outperform large company shares, value stocks outperform growth stocks, and share prices adjust slowly to earnings surprises, as empirical confirmation of their beliefs.
Four implications of market efficiency for corporate finance are:
1. Managers cannot fool the market through creative accounting.
2. Firms cannot successfully time issues of debt and equity.
3. Managers cannot profitably speculate in foreign currencies and other instruments.
4. Managers can reap many benefits by paying attention to market prices.

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Thursday 26 January 2012

13.1 Can Financing Decisions Create Value?

13.2 A Description of Efficient Capital Markets

Foundations of Market Efficiency

13.3 The Different Types of Efficiency

The Weak Form

The Semi-Strong and Strong Forms

Some Common Misconceptions about the Efficient Market Hypothesis

13.3 The Different Types of Efficiency

The Weak Form

The Semi-Strong and Strong Forms

Some Common Misconceptions about the Efficient Market Hypothesis

The Semi-Strong Form

The Strong Form

13.5 The Behavioural Challenge to Market Efficiency

Rationality

Independent Deviations from Rationality

Arbitrage

13.6 Empirical Challenges to Market Efficiency

Limits to Arbitrage

Earnings Surprises

Size

Value versus Growth

13.7 Reviewing the Differences

Representativeness

Conservatism

The Academic Viewpoints

13.8 Implications for Corporate Finance

Accounting Choices, Financial Choices, and Market Efficiency

The Timing Decision

Speculation and Efficient Markets

Information in Market Prices

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