Harvard University Corporate Finance Security Prices Question After reviewing the attached Chapter 13, prepare a 300-400 In this posting, you should also a

Harvard University Corporate Finance Security Prices Question After reviewing the attached Chapter 13, prepare a 300-400 In this posting, you should also answer the following question: 1. Include Finance Concepts discussed in Chapter 32. What do we mean by the following phrase? “Security prices reflect all publicly available information” Please, include an example. page 390
PART FOUR: CAPITAL STRUCTURE AND DIVIDEND
POLICY
Efficient Capital
Markets and
Behavioral
Challenges
13
OPENING
CASE
The decade of the 2000s proved to be one of the more
interesting in stock market history. Following a spectacular rise in
the late 1990s, the NASDAQ lost about 40 percent of its value in
2000, followed by another 30 percent in 2001. The ISDEX, an
index of Internet-related stocks, rose from 100 in January 1996 to
1,100 in February 2000, a gain of about 1,000 percent! It then fell
like a rock to 600 by May 2000. The end of the decade saw
almost exactly the reverse. From January 2008 through March 9,
2009, the S&P 500 lost about 57 percent of its value. Of course,
from that point through February 2011, a period of about 700
days, the S&P 500 doubled in value. This climb was the fastest
doubling of the S&P since 1936 when it doubled in just 500 days.
The performance of the NASDAQ in the late 1990s, and
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particularly the rise and fall of Internet stocks, has been
described by many as one of the greatest market “bubbles” in
history. The argument is that prices were inflated to economically
ridiculous levels before investors came to their senses, which
then caused the bubble to pop and prices to plunge. Debate over
whether the stock market of the late 1990s really was a bubble
has generated much controversy. Similarly, the reasons behind
the market’s collapse in 2008 and its subsequent rebound in
2009 and early 2010 are being hotly debated. In this chapter, we
will discuss the competing ideas, present some evidence on both
sides, and then examine the implications for financial managers.
Please visit us at corecorporatefinance.blogspot.com for the latest developments in
the world of corporate finance.
13.1 A DESCRIPTION OF EFFICIENT
CAPITAL MARKETS
If capital markets are efficient, corporate managers cannot create value by
fooling investors, and market values reflect underlying intrinsic values.
The key to understanding the concept of the efficient market is the
relationship between market values and information.
An efficient capital market is one in which stock prices fully reflect
available information. To illustrate how an efficient market works,
suppose the 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 a positive NPV.
Now consider a share of stock 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 scientist to develop the new autofocusing 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
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price of the stock will not necessarily change. Suppose,
instead, that hiring the scientist is a positive NPV transaction. In this case,
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the price of shares in 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 price of FCC’s shares take place?
Assume that the hiring announcement is made in a press release on
Wednesday morning. In an efficient market, the price of shares in FCC
will immediately adjust to this new information. Investors should not be
able to buy the stock on Wednesday afternoon and make a profit on
Thursday. This would imply that it took the stock market a day to realize
the implication of the FCC press release. The efficient market hypothesis
predicts that the price of shares of FCC stock 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 for the securities they issue is
the present value. Thus, valuable financing opportunities that arise
from fooling investors are unavailable in efficient capital markets.
FIGURE 13.1
Reaction of Stock Price to New Information in Efficient and Inefficient
Markets
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Figure 13.1 presents several possible adjustments in stock prices. The
solid line represents the path taken by the stock 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 delayed 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
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paths that the stock price might take in an inefficient
market. If the price of the stock were to take several days to adjust, trading
profits would be available to investors who suitably timed their purchases
and sales.1
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)
rationality, (2) independent deviations from rationality, and (3) arbitrage.2
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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 stock prices in a rational way. In our example, investors will
use the information in FCC’s press release, in conjunction with existing
information on 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 price might be, say, $40, no one
would now transact at that price. Anyone interested in selling would only
sell at a price of at least $45 (= $40 + 5). And 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, since 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 rational. 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, 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 stock price would likely rise beyond what market
efficiency would predict.
However, due to 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 skeptical about the
benefits of the telephone, the copier, the automobile, and the motion
picture. Certainly, they could be overly skeptical about this new camera. If
investors were primarily of this type, the stock price would likely rise less
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than market efficiency would predict.
But suppose that about as many individuals were irrationally optimistic
as were irrationally pessimistic. Prices would likely 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
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throes of extreme pessimism. But even here, there is an
assumption that will produce efficiency.
ARBITRAGE Imagine a world with two types of individuals: the
irrational amateurs and the rational professionals. The amateurs get caught
up in their emotions, at times believing irrationally that a stock 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 stocks 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 stock
prices coldly and clearly, and they act accordingly. If a stock is
underpriced, they would buy it. If overpriced, they would sell it. And their
confidence would likely be greater than that of the amateurs. While an
amateur might risk only a small sum, these professionals might risk large
ones, knowing as they do that the stock is mispriced. Furthermore, they
would be willing to rearrange their entire portfolio in search of a profit. If
they find that General Motors is underpriced, they might sell the Ford
stock they own in order to buy GM. Arbitrage is the word that comes to
mind here, since 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 will still be
efficient.
13.2 THE DIFFERENT TYPES OF
EFFICIENCY
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In our previous discussion, we assumed that the market responds
immediately to all available information. In actuality, certain information
may affect stock 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 on 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 stock after it has
gone up three days in a row and recommends selling a stock 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 in past stock prices. Thus, the above
strategy would not be able to generate profits if weak form efficiency
holds.
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 stock to acquire. If it
were possible to make extraordinary profits simply by finding patterns in
stock price movements, everyone would do it, and any profits would
disappear in the scramble.
This effect of competition can be seen in Figure 13.2. Suppose the
price of a stock 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.
The Semistrong and Strong Forms
If weak form efficiency is controversial, even more contentious are the two
stronger types of efficiency, semistrong form efficiency and strong form
efficiency. A market is semistrong form efficient if prices page 394
reflect (incorporate) all publicly available information,
including information such as published accounting statements for the firm
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as well as historical price information. A market is strong form efficient if
prices reflect all information, public or private.
FIGURE 13.2
Investor Behavior Tends to Eliminate Cyclical Patterns
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 Figure 13.3. Thus, strong form efficiency implies
semistrong form efficiency, and semistrong form efficiency implies weak
form efficiency. The distinction between semistrong form efficiency and
weak form efficiency is that semistrong 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
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page 395
To illustrate the different forms of efficiency, imagine an investor who
always sold a particular stock after its price had risen. A market that was
only weak form efficient and not semistrong 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 stock is
overvalued.
Now consider a firm reporting increased earnings. An individual might
consider investing in the stock after hearing of the news release giving this
information. However, if the market is semistrong 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 stock and that is
known to at least one investor is, in fact, fully incorporated into the stock
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
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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 of the stock.
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 stock 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.
Semistrong form efficiency, though, implies more sophisticated
investors than does weak form efficiency. An investor must be skilled at
economics 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 farther down the road than
semistrong 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 unfavorable 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 below.
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, 4 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
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excess return is defined with respect to some benchmark
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expected return, such as that from the security market line
(SML) of Chapter 11. 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 stocks that deal in genetic
engineering. Would you really want all of your stock investments in two
such stocks?
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 stock is a fair price in the sense that it reflects the value
of that stock given the information that is available about it. Shareholders
need not worry that they are paying too much for a stock 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 skeptical of efficiency
because stock prices fluctuate from day to day. However, daily price
movement is in no way inconsistent with efficiency; a stock 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.
STOCKHOLDER DISINTEREST Many laypersons are skeptical 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
stock on a given day is generally far less than the number of people
following the stock. This is true because an individual will trade only
when his appraisal of the value of the stock differs enough from the market
price to justify incurring brokerage commissions and other transaction
costs. Furthermore, even if the number of traders following a stock is small
relative to the number of outstanding shareholders, the stock can be
expected to be efficiently priced as long as a number of interested traders
use the publicly available information. That is, the stock price can reflect
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the available information even if many stockholders never follow the stock
and are not considering trading in t…
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