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Chapter 12Fundamentals of Corporate FinanceThird Edition
Corporate
Financing and
the Lessons of
Market
Efficiency
Brealey Myers Marcus
slides by Matthew Will
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Topics Covered
?Investment Decision vs,Financing Decision
?Market Efficiency
?Weak form efficiency
?Semi-strong form efficiency
?Strong form efficiency
?Lessons of Market Efficiency
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Investment vs,Financing
?Investment decision are made based on the risk of
the project,with total disregard for how the
project will be financed (flotation costs being the
exception).
?Financing decisions are made based on the
conditions in the capital markets,with little
consideration for the investment being made
(project specific funding being the exception,
IRBs are a good example),
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Market Efficiency Theory
Capital markets reflect all relevant
information,You cannot consistently earn
excess profits,
Market Efficiency
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Market Efficiency
Efficient Capital Markets - Financial markets in
which security prices rapidly reflect all relevant
information about asset values.
Random Walk - Security prices change randomly,
with no predictable trends or patterns.
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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).
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Random Walk Theory
$103.00
$100.00
$106.09
$100.43
$97.50
$100.43
$95.06
Coin Toss Game
Heads
Heads
Heads
Tails
Tails
Tails
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Random Walk Theory
S& P 5 0 0 F i v e Y e a r T r e n d?
or
5 y r s o f th e C o i n T o s s G a m e?
80
130
180
Mo n th
L
e
v
e
l
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Random Walk Theory
S& P 5 0 0 F i v e Y e a r T r e n d?
or
5 y r s o f th e C o i n T o s s G a m e?
80
130
180
230
Mo n th
L
e
v
e
l
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Market Efficiency
Technical Analysts - Investors who attempt to
identify over- or undervalued stocks by searching
for patterns in past prices.
Fundamental Analysts - Analysts who attempt to
fund under- or overvalued securities by analyzing
fundamental information,such as earnings,asset
values,and business prospects.
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Efficient Market Theory
Last
Month
This
Month
Next
Month
$90
70
50
EI’s Stock
Price
Cycles
disappear
once
identified
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Market Efficiency
Weak Form Efficiency - Market prices rapidly
reflect all information contained in the history
of past prices.
Semi-Strong Form Efficiency - Market prices
reflect all publicly available information.
Strong Form Efficiency - Market prices reflect
all information that could in principle be used
to determine true value.
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Efficient Market Theory
-16
-11
-6
-1
4
9
14
19
24
29
34
39
D a y s R e l a ti v e to a n n o n c e m e n t d a te
C
u
m
u
l
a
ti
v
e
A
b
n
o
r
m
a
l
R
e
tu
r
n
(%
)
Announcement Date
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Market Efficiency 0
5
10
15
20
25
A
v
e
ra
g
e
re
t
u
rn
,
p
e
rc
e
n
t
H
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g
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t
L
o
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s
t
B o o k - M a rk e t R a t i o
F a m a & F r e n c h
R e tu r n v s, B o o k -Ma r k e t
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Lessons of Market Efficiency
?Markets have no memory
?Trust market prices
?There are no financial illusions
?Do it yourself diversification
?Seen one stock,seen them all
?Reading the entrails