Some Notes on Value Creation and Market Efficiency

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Nathan Griffith
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1 Some Notes on Value Creation and Market Efficiency Wealth Creation by a Corporation Goal is to maximize shareholders wealth In a single period, wealth can be created if cash inflows exceed cash outflows by more than what we could earn by investing somewhere else with equal risk In a multi-period decision process, we measure wealth creation by Net Present Value (NPV) Net Present Value is the difference between present value of cash outflows and present value of cash inflows Assume you have the following information on Project X: Initial outlay: -$1,100,000 and Required return: 10% Annual cash revenues and expenses are as follows: Year Revenues Expenses Net Cash Flow 1 $1,000,000 $500,000 $500,000 2 $2,000,000 $1,000,000 $1,000,000 Verify that NPV = +$180,991 If there are 100,000 shares outstanding, then stock price would increase by $180,991/100,000 = $1.81 when managers announce that they will invest in project X. The last statement is true only if managers and investors have the same information set. Why NPV? A firm is created when security holders supply the funds to acquire assets that will be used to produce and sell a good or a service;

2 The market value of the firm is based on the present value of the cash flows it is expected to generate; Additional investments are good if the present value of the increase in the expected cash flows exceeds their cost; Thus, good projects are those which increase firm value - or, put another way, good projects are those projects that have positive NPVs! Moral of the story: Invest only in projects with positive NPVs. Another decision criteria: IRR: The return on the firm s invested capital. IRR is simply the rate of return that the firm earns on its capital budgeting projects IRR is the rate of return that makes the PV of the cash flows equal to the initial outlay or NPV = 0 Market Efficiency What is capital market efficiency? Stock prices are in equilibrium or are fairly priced If this is true, then you should not be able to earn abnormal or excess returns Efficient markets DO NOT imply that investors cannot earn a positive return in the stock market In efficient markets NPV=0 What makes a market efficient? There are many investors out there doing research As new information comes to market, this information is analyzed and trades are made based on this information Therefore, prices should reflect all available public information

3 What do efficient markets really mean? Efficient markets do not mean that you can t make money They do mean that, on average, you will earn a return that is appropriate for the risk undertaken and there is not a bias in prices that can be exploited to earn excess returns Market efficiency will not protect you from wrong choices if you do not diversify you still don t want to put all your eggs in one basket Price ($) Overreaction and correction Delayed reaction Efficient market reaction Days relative to announcement day (Day 0)

On February 25, 2002 WSJ Reported In a surprise offer made late last Thursday, Northrop offered to pay $47 in its stock for each TRW share outstanding and offered to assume $5.5 billion in debt.

4 On February 25, 2002 WSJ Reported In a surprise offer made late last Thursday, Northrop offered to pay $47 in its stock for each TRW share outstanding and offered to assume $5.5 billion in debt. The move came as TRW s management team and share price were reeling. Just two days earlier, TRW's chairman and chief executive, David Cote, abruptly resigned after a year on the job to accept a new position as CEO of Honeywell International Inc., sending TRW s stock price falling sharply. In a brief statement, TRW officials called Northrop s timing regrettable. What do you think is likely to happen to TRW s share price? Continue on report While TRW, Cleveland, said its board would review the offer, the initial internal reaction among senior TRW executives was that the offer was too low to be considered seriously, said people familiar with their thinking. The day before Mr. Cote s resignation, TRW's stock was trading around $45 a share. Wall Street analysts and bankers said the company could easily fetch between $53 and $58 a share, possibly higher if other buyers stepped up and sparked a bidding war.

5 At 4 p.m. in New York Stock Exchange composite trading on Friday, TRW surged $10.50, or 26%, to $50.30, rising above the offer price on expectations that Northrop may have to raise its bid or another suitor may be willing to pay more. Northrop slipped $7.85, or 6.7%, to $ Weak Form: Prices reflect all past market information such as price and volume If the market is weak form efficient, then investors cannot earn abnormal returns by trading on market information Implies that technical analysis will not lead to abnormal returns Empirical evidence indicates that markets are generally weak form efficient Semi-strong Form: Prices reflect all publicly available information including trading information, annual reports, press releases, etc. If the market is semi-strong form efficient, then investors cannot earn abnormal returns by trading on public information Implies that fundamental analysis will not lead to abnormal returns

Strong Form: Prices reflect all information, including public and private If the market is strong form efficient, then investors could not earn abnormal returns regardless of the information they

6 Strong Form: Prices reflect all information, including public and private If the market is strong form efficient, then investors could not earn abnormal returns regardless of the information they possessed Empirical evidence indicates that markets are NOT strong form efficient and that insiders could earn abnormal returns Diversification Investing in more than one security to reduce risk If two stocks are perfectly positively correlated, diversification has no effect on risk If two stocks are perfectly negatively correlated, the portfolio is perfectly diversified

Using Goal Seek in Excel 1 2 3 A B C X + Y = 5. If Y is 3 then what is X?

7 Using Goal Seek in Excel A B C X + Y = 5. If Y is 3 then what is X? X Y Result 3 3 Note A3 and B3 are input cells and C3 is output cell C3 entry is =A3+B3 For Goal Seek go to Tools Goal Seek then

Chapter 12. Some Lessons from Capital Market History. Dongguk University, Prof. Sun-Joong Yoon

Chapter 12. Some Lessons from Capital Market History Dongguk University, Prof. Sun-Joong Yoon Outline Returns The Historical Record Average Returns: The First Lesson The Variability of Returns: The Second