EMBA 807 Corporate Finance Dr. Rodney Boehme
CHAPTER 13 CORPORATE-FINANCING DECISIONS
AND EFFICIENT CAPITAL MARKETS
Assigned problems are 5, 8, 10, 11, 12, 14, 16, and 22.
I. Introduction to Market Efficiency
A Description of Efficient Capital Markets
Prices in informationally efficient capital or financial markets should reflect allavailable
information. An important consequence of market efficiency is that investments in publicly
traded financial securities, such as stocks and bonds, are zero NPV investments (as opposed to
the assumed positive NPVs of most real or productive assets). Investors should expect to earn a
fair or normal return that is consistent with the risk (defined by CAPM or APT) of the security.
Companies should expect to receive a fair price when they issue securities.
Current prices should represent a fair and unbiased forecast or estimate of the true, intrinsic, or
fundamental value of the firm, i.e., the Present Value of all future expected cash flows. If this
were not the case, we would find many instances where security prices were systematically
biased, i.e., either consistently underpriced or overpriced.
Some reasons why market efficiency is a critical issue and concept:
1. It affects the price that the firm will receive for any new stocks and bonds that it may issue.
Also, if a firm can sell new stock that is overvalued, it is perhaps likely to do such.
2. It affects the cost of capital or required rate of return on securities. The cost of capital affects
the capital budgeting or new capital expenditure decisions.
3. If you want to link management compensation to stock price or shareholder value, then it is
especially important that the stock price be representative of the true value of the firm, i.e.,
stockholders want a stock price that is fair and unbiased.
4. An asset’s price should be driven by unbiased estimates of future cash flows and the true
systematic risk associated with the cash flows. If this were not the case, investors would be
able to earn returns that are inconsistent with the true level of risk of an asset. Portfolio
managers are very interested in any mispricing in the stock market. A mispriced stock would
be thought of as cash lying in the street waiting for someone to pick it up.
Normal versus Abnormal Returns
If financial markets are not efficient, then strategies would exist that can systematicallyearn
above normal or below normal returns, referred to as abnormal returns. However, in order to
actually calculate any abnormal return for any given asset, we first need some Asset Pricing
Model such as the Arbitrage Pricing Theory or Capital Asset Pricing Model that gives us an
estimate or idea of what the normal or expected return to that asset should have been.
Abnormal Return = ActualReturn observed – Expected Return
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The expected or normal return of the asset is based on: (1) the stock’s level of risk and (2) what
actually happened with the relevant systematic or macroeconomic source(s) of risk. For
example, in a CAPM world, if the overall market goes down, the stock under investigation would
likely also have gone down in price.
Reaction of Stock Price to New Information
In an efficient market, prices respond instantaneously to new and material information and fully
reflect that information. Delayed responses (under-reaction) and overreaction to new
information would suggest that markets are inefficient. Next, we look at three information sets
and the corresponding level or form of market efficiency.
II. Information and Forms of Efficient Market Hypothesis (EMH)
Three information sets are used to describe the EMH. Note that set 1 is a subset of 2 and that
both 1 and 2 are subsets of 3. Each set corresponds to one form of the EMH as discussed below.
1. Historic stock prices and other market related information (e.g., trading volume, etc.)
2. Publicly available information (this also includes all historical market information)
3. All information relevant to a stock (both public and private information)
Three forms of Efficient Market Hypothesis or EMH
1. Weak form efficiency: asset prices already reflect all historical market related trading
information such as past prices, returns, trading volume, or trends in volume or prices. Most
tests show that this information cannot be used to generate or earn abnormal returns after
adjusting for risk. This makes sense because this information is available at almost zero cost.
If the market is weak-form efficient, thentechnical analysis or chart reading should not
produce abnormal returns. Stock prices should closely follow a random walk.
Individuals have an unfortunate tendency to look for patterns or trends, even in random
series. Take a good look at the four graphs on page 10 of these notes. Two of the graphs
are actual performance of the U.S. market for a 10-year period, and the other two are
computer generated from a random walk model (an upward trend of 10% per year with 20%
annual standard deviation). See if you can tell which graphs are real!
2. Semi-strong form efficiency: asset prices already reflect all information that is publicly
available, i.e., earnings, dividends, analyst forecasts, expectations of the future, etc. Most
tests show that material public announcements are accompanied by an immediate change in
price. In a semi-strong efficient market, the market's reaction to new and material
information should be both instantaneous and unbiased, i.e., without any systematic pattern
of over or underreaction. In addition, the market should only react to the extent that new
information differs from what had been expected. Semi-strong efficiency also means that
The problem is that perhaps people have an incomplete concept of what randomness should look like. A random
walk in stock prices is essentially an overall upward trend with a noise term that produces a variation around the
overall upward trend.
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most financial analysis work or fundamental analysis, based on using public information,
should not work.
Opportunities may occasionally exist that produce above normal or excess returns. However,
after the information or strategies become known to the public, they should no longer
produce excess returns; e.g., the January effect in small stocks has vanished. Also, a talented
investment analyst might still be able to beat the market, provided that he/she is able to
consistently interpret information better than the competition can.
3. Strong form efficiency: asset prices already reflect all private and public information. We
know that inside information is very valuable to anyone that chooses to (illegally in most
cases) act upon this information, so the market is certainly not strong formefficient.
Implications of The Semi-Strong Form Market Efficiency:
• Stock prices are expected to increase over time, but future returns are expected to be
consistent with the systematic risk.
• Investments in financial assets are expected to be ZERO Net Present Value. This means that
you should expect to earn an average future return that is determined by the systematic risk of
• What if no one performed security analysis? Then the first person that becomes an analyst
will find countless mispriced assets and trading rules that earn excess or abnormal returns.
Such profitable opportunities would certainly lead to many more individuals entering the
analyst field. Competition will quickly begin to eliminate most of the mispriced assets.
• Due to intense competition, it will become difficult to earn abnormal returns. The marginal
benefit of analysis will just equal the marginal cost of analysis for the average analyst or
• It thus follows that individuals should be exceedingly suspicious of anyone that advertises
some investment technique that earns abnormal returns. 2f the method really works, then any
rational person would keep the technique undisclosed! This holds for the weak-form market
efficiency as well, as many attempt to sell methods for technicalanalysis.
III. The Evidence for Market Efficiency:
• Aremarkets strong form efficient? Certainly not.
• Aremarkets weak-form efficient? Evidence strongly suggests yes. Random successes look
appealing, but most tests are not supportive of trading strategies that use market related data.
After all, how many industrial corporations prefer to give away their patents, knowledge, or other proprietary
information that generates NPV? Given that industrial firms don’t give away these items of knowledge, it follows
that successful trading methods or strategies won’t be disclosed either.
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• Aremarkets perfectly semistrong efficient? No. The recent bubble in internet/technology
stocks is a somewhat obvious example of prices not reflecting their fundamental value.
• Aremarkets largely semistrong efficient? Yes, based on most of the evidence, especially for
event studies and mutual fund performance.
However, there are many reported anomalies in stock prices. Do these anomalies represent
actual mispricings that an astute portfolio manager can convert into abnormal returns (ARs)?
No, for the most part. Perhaps they once worked, before they became public knowledge. Also,
what might produce apparent or measured abnormal returns on paper might be difficult to
actually implement using actual money.
Tests of the EMH fall under three major categories:
1. Tests for random walk in stock prices
2. Event Studies
3. Performance of professional investors
All these tests compare observed stock returns against returns predicted by the EMH, controlling
for systematic risk. We first need to understand what any stock's normal returns should look
like, based upon its level of risk. Therefore, tests of the EMH are joint tests market efficiency
and the asset pricing model (e.g. the CAPM or APT) used to estimate systematic risk.
Tests of the Weak Form EMH (do prices follow a Random Walk?)
Tests for serial correlationare often used to test the weak form EMH.
Positive serial correlation: above (below) normal returns are followed by subsequent above
(below) normal returns, otherwise referred to as momentum .
Negative serial correlation: above (below) normal returns are followed by subsequent below
(above) normal returns, otherwise referred to as reversals in returns.
Both positive serial correlation and negative serial correlation would imply violations of the
weak form EMH if they are found to exist and also if they are economically significant after
accounting for transactions costs. The majority of empirical evidence isconsistent with the
Tests of Semi-strong Form Efficiency
Event studies look at stock price reaction to new information released to the public. Delayed
responses or overreaction to new public information implies a violation of the semi-strong form
EMH. There is a little mixed empiricalevidence fromevent studies, but efficiency is generally
supported. In addition, the problem of jointly testing the underlying asset pricing model and
market efficiency is still unresolved, i.e., first you need to know what the normal returns should
Research that reports market inefficiencies tend to get reported, while those that support market efficiency are not
as exciting. If you perform 20 studies of events that have no actual abnormal returns, onaverage one of them will
by pure chance report spurious abnormal returns that are statistically significant at the 5% level. That study would
be exciting, while the other 19 are not interesting.
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look like before any inference can be made concerning market efficiency. Also, always
remember that the true asset pricing model is not known.
Mutual fund performance studies compare the return on actively managed mutual funds to
returns on a passivebroad-based index mutual fund, e.g., a mutual fund that onlyattempts to
match the S&P 500 or Willshire 5000 indices. Since trading on insider information is illegal,
most active fund managers have to rely on public information to formulate their investment
strategies. The majorityof mutual fund studies find that most active mutual fund managers do
not outperform passive index funds, supporting the semi-strong form EMH.
The Value Line Investment Surveypublishes information about stocks that have broad investor
interest. Value Line ranks stocks on a scale from 1 to 5. The stocks ranked 1 and 5 are expected
to have the best and worst future performance, respectively. Research has shown that,on paper,
the 1 ranked stocks have indeed outperformed the 5 ranked stocks. However, the two mutual
funds that Value Line manages have actually underperformed the market, even though they use
the Value Line ranking system in formulating their investment decisions. Apparently, what
looks great on paper cannot always be implemented to generate above normal returns.
Some Contrary Views of the EMH
Size: Studies have shown that small firms (measured by market capitalization) earn higher
returns than large firms after adjusting for systematic risk (Beta CAPM risk in these studies).
One controversy on this finding is whether a correct or properly specified asset pricing model
was used to adjust for systematic risk. Returns cannot be said to be above or below normal when
you don't have a good idea of what the "normal" returns should look like.
In any case, small firms do not constitute much value in the overall market. Of all the publicly
traded firms in the U.S., the largest 10% of firms make up around 85% of the total value of the
U.S. stock market. The smallest 10% of firms make up only about 0.3% of the overall market
value. Even the smallest 30% of firms only make up about 2.5% of the overall market value.
Temporal Anomalies : Researchers discover several stylish facts (patterns) in stock returns,
implying that stock prices do not follow a random walk. However, these findings are not strong
evidence against the EMH because these patterns cannot be exploited to earn abnormal profits
after accounting for transaction costs. Furthermore, one of these patterns (negative average
return on Mondays) has disappeared recently.
Value versus Glamour: This is the latest battleground for the EMH. Several studies show that
public information (the ratio of book value of equity to market value of equity or BV/MV) can
be used to select stocks that produce abnormal returns. If the finding is not driven by risk, then a
challenge to the EMH exists. The verdict on this topic is stil