Principles of Corporate Finance

Transcription

1 Principles of Corporate Finance Chapter 14. Efficient Markets and Behavioral Finance Ciclo Profissional 2 o Semestre / 2008 Graduação em Ciências Econômicas V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

2 Topics covered 1 What is an efficient market? 2 The evidence against market efficiency 3 Behavioral Finance V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

3 Net present value of borrowing One can apply to financial asset the techniques developed for real assets The government has a policy to encouraging small business It offers to lend to your firm $100,000 you have to repay in 10 years at 3% The firm is liable of interest payments of $3,000 in each year 10 3, , 000 NPV = +100, 000 (1 + r) t (1 + r) 10 t=1 V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

4 Net present value of borrowing What is the correct opportunity cost of capital? How much the capital market would pay for these liabilities of your firm? The correct rate r to discount theses cash flows is the opportunity cost of other (marketed) securities issued by the firm Suppose this rate is 10%, then NPV = +100, , 988 = +$43, 012 Obviously borrowing at 3% is a good deal when the fair rate is 10% The opportunity worths $43,012 V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

5 Differences between investment and financing decisions Financing decisions are easier to reverse: their abandon value is higher It is harder to make money by smart financial strategies Financial markets are more competitive than product markets It is more difficult to find positive NPV financing strategies than positive NPV investment strategies The market for investment is not a perfect competitive market There are few competitors that specialize in the same line of business in the same geographical area A firm may own some unique assets like patents, expertise or reputation that give it an edge over its competitors The investors who supply financing are numerous, and they are smart: Money attracts brains V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

6 Price changes are random Prices of stocks and commodities seem to follow a random walk Kendall, M.G. The analysis of economic time series, Part I. Prices Journal of the Royal Statistical Society 96, 1953 Bachelier, L. Théorie de la spéculation Gauthiers-Villars, 1900 V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

7 Random walk You are given $100 to play a game At the end of each week a coin is tossed If it comes up heads, you win 3% of your investment If it is tails, you lose 2.5% This is a random walk with expected drift (expected outcome) of 0.25% V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

8 Empirical evidence One consider two charts One corresponds to the actual Standard and Poor s Index for February 2002 to February 2007 The other one is a series of cumulated random numbers V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

9 Can you tell which is which? V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

10 Empirical evidences Assume prices follow a random walk Then the price changes should be independent of one another Like the gains and losses in the coin-tossing game We propose to illustrate this for four stocks Each dot refers to a pair of days (t, t + 1) which coordinates represent the return for the two dates V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

11 Empirical evidences V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

12 Empirical evidences If there was a systematic tendency for increases to be followed by decreases, there would be many dots in the southeast quadrant and few in the northeast quadrant One can also calculate the correlation coefficient between each day s price change and the next For BP and Sony there was a negligible tendency for price rises to be followed by further price rises For Microsoft and Fiat there was a negligible tendency for price rises to be followed by further price falls V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

13 Predictable cycles The empirical evidences suggest that today s price change gives investors almost no clue as to the likely change tomorrow Imagine this was not the case: changes in Microsoft s stock price are expected to persist for several months Consider an upswing started last month from $20 to $30 today When investors perceive this, they expect that the price will reach $40 next month If this upswing is expected to carry the price to $40 next month, investors will rush to buy until the price reaches the PV of $40 next month V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

14 Market efficiency As soon as a cycle becomes apparent to investors, they immediately eliminate it by their trading V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

15 Market efficiency If past price changes can be used to predict future price changes Then investors try to take advantage of the information and price adjust immediately As a result, all the information in past prices is reflected in today s stock price, not tomorrow s If markets are competitive, today s stock price could (or should) also reflect all the information that is available to investors today No one earns superior returns in such a market and collecting more information won t help because all the available information is already impounded in today s stock prices V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

16 Three forms of market efficiency Economists define three levels of market efficiency weak form: Prices reflect the information contained in the record of past prices If markets are efficient in the weak sense, then it is impossible to make consistently superior profits by studying past returns semi-strong form: Prices reflect not just the information revealed by past prices but also all other published information (financial press, public announcements of earnings, issuance of new stock, proposal to merge two companies) strong form: Prices reflect all the information that can be acquired by painstaking analysis of the company and the economy If market efficiency form is strong we should not observe any superior investment manager who can consistently beat the market V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

17 Weak efficient market: The evidence Some investors claim to find patterns in security prices Researchers measured the profitability of some of the trading rules used by those investors It appears that throughout the world there are few patterns in day-to-day returns V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

18 Semi-strong efficient market: The evidence In order to test the semi-strong form of efficiency, one should measure how rapidly security prices respond to different items of news Let us try to understand how stock prices of takeover targets respond when the takeovers are first announced One could simply calculate the average return on target-company stocks in the days leading up to the announcement and immediately after it To avoid the contamination from movements in the overall market around the announcement dates, one should adjust for market movements A simple solution is to consider adjusted stock return = return on stock return on maket index V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

19 Semi-strong efficient market: The evidence One may consider a refined adjustment The market model of CAPM tell us that Expected stock return = α + β return on market index where α represents how much on average the stock price changed when the market index was unchanged In that case, the abnormal return can be defined by abnormal stock return = actual return expected stock return This abnormal stock return abstracts from the fluctuations in the stock price that results from marketwide influences One could also follow the APT model and consider the three-factor model of Fama French V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

20 Semi-strong efficient market: The evidence We take a sample of 17,000 firms that were targets of takeover attempts Acquiring firms are usually willing to pay a large premium over the current market price of the acquired firm The stock price of an acquired firm increases in anticipation of the takeover premium Empirical results show that the stock price of the target takes a big upward jump the day of announcement After the announcement, the run-up is over The announcement of the takeover attempt seems to be fully reflected in the stock price on the announcement day V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

21 Semi-strong efficient market: The evidence A study by Patell and Wolson showed that adjustment in prices occurs within 5 to 10 minutes after the announcement of latest earnings or dividend change V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

22 Strong efficient market: The evidence To test the strong form one can examine the performance of the recommendations of professional security analysts and mutual or pension funds One-third of the years mutual funds beat the market Two-third of the time it is the way around V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

23 Strong efficient market: The evidence V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

24 Strong efficient market: The evidence Convinced by such evidence, many professionally managed funds have given up the pursuit of superior performance They simply buy the index which maximizes diversification and minimizes the costs of managing the portfolio Corporate pension plans now invest over a quarter of their U.S. equity holdings in index funds We cannot have all investors holding index funds Otherwise nobody will be collecting information and prices will not respond to new information when it arrives Strong-efficiency needs some smart investors who gather information and attempt to profit from it To provide incentives to gather costly information, prices cannot reflect all information, there must be some profits available to allow the costs of information to be recouped V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

25 The evidence against market efficiency In efficient markets, it is not possible to find expected returns greater (or less) than the risk-adjusted opportunity cost of capital The price P of a financial strategy (portfolio) leading to cash flows (C t ) t should satisfy C t P = (1 + r) t t=1 The right-hand is called fundamental value If the price differs from the fundamental value, then investors can earn more than the cost of capital by selling if the price is too high by buying when it is too low V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

26 The evidence against market efficiency In order to determine if the market is efficient one should be able to provide opportunity costs of capital For this, one should adopt an asset pricing model that specifies the relationship between risk and expected return CAPM APT with three-factors Any test of market efficiency is then a combined test of efficiency and the asset pricing model Similarly, any test of asset pricing model is a combined test of the model and market efficiency V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

27 Do investors respond slowly to new information? There is a puzzle related to short-term behavior of stock prices Returns appear to be higher in January that in other months Returns seem to be lower on a Monday than on other days Most of the daily return comes at the beginning and end of the day Professional traders can try to make money from such short-term patterns These short-term changes do not affect the corporate financial manager s decisions More troubling is an apparent long-term delay in the reaction to news V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

28 The earnings announcement puzzle We report the stock performance of firms over the six months following the announcement of unexpected good or bad earnings during the years 1972 to 2001 The 10% of the stocks of firms with the best earning news outperform those with the worst news about 1% per month over the six-month period following the announcement It seems that investors underreact to the earnings announcement and become aware of the full significance only as further information arrives V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

29 The earnings announcement puzzle V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

30 Are stock prices determined by fundamentals? For many people the anomalies are not convincing evidence against market efficiency since they can be explained by inadequate asset pricing models However there are some examples of inefficiency that can t be dismissed so easily This is the case of Siamese twins two securities with claims on exactly the same cash flows that are trade separately and have different stock prices Before July of 2005, two companies were sharing the dividends and earnings of a joint firm the Dutch company Royal Dutch Petroleum got 60% the British company Shell T&T got 40% One would expect that the market value of Royal Dutch shares would always be equal to 60/40=1.5 times the value of Shell V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

31 Siamese twins The two shares often traded away from parity of 1.5 to 1 for long periods V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

32 Bubbles Bubbles are also evidence that prices can disconnect from fundamentals Bubbles can occur when asset prices rise rapidly and more and more investors jump into the game The assumption behind the jump is that prices will continue to rise Bubbles can be self-sustained for a while It can be rational to join a bubble as long as you are sure that there will be greater fools to follow that you can sell out to However, lots of money will be lost when the bubble finally bursts V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

33 Examples of bubbles The Dutch Tulipmania of 1635 The Mississippi Land bubble of The bubble in American stocks in the 1920s just before the Great Depression Japanese stock and real estate markets in the 1980s Taiwanese stocks in 1987 Technology (Dot-com) stocks in U.S. and other countries in the late 1990s More recently, the U.S. housing bubble V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

34 The Japanese bubble The Nikkei 225 Index rose about 300% between the start of 1985 until December 1989 After a sharp increase in interest rates at the beginning of 1990, stock prices began to fall By October 1990, the Nikkei had sunk to about half of its peak In April 2003 it had fallen 80% In March 2007 it was still less than half its level 17 years before The few hundred acres of land under the Emperor s Palace in Tokyo was worth as much as all the land in Canada or California V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

35 The Dot.com boom The Nasdaq Composite Index (heavy weighting in high-tech stocks) rose 580% from the start of 1995 to its high in March 2000 The boom ended as rapidly as it began and by October 2002 the Nasdaq index has fallen 78% from its peak Yahoo! shares began trading in April 1996 appreciated by 1,400% in four years At this point the stock was valued at $124 billion, more than market value of GM, Heinz, and Boeing combined It is difficult to believe that future earnings growth would ever be sufficient to provide investors with a reasonable return V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

36 It is difficult to value stocks Consider the market peak in 2000 Assume we want to check whether the stocks forming the S&P s Composite Index were fairly valued Let us use the constant growth formula since firms in this index are mostly mature firms for which this assumption is plausible In 2000 the annual dividends paid by the companies in the index totaled about $154.6 million Suppose that the dividends were expected to growth at a steady rate of 8% a year Suppose that investors required a return of 9.2% The constant-growth formula gives a value for the common stocks of PV(common stocks) = DIV r g = = $12, 883 million This was roughly their total value in March 2000 V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

37 It is difficult to value stocks How confident could an investor be about these figures Perhaps the likely dividend growth was only 7.4% per year In that case the value of common stocks would decline to PV(common stocks) = DIV r g = = $8, 589 million This was the value of these stocks in October 2002 The 33% of decline in the S%P s Index could have been caused simply by investors revising their forecast of dividend growth by 0.6 percentage points V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

38 It is difficult to value stocks Investors find it easier to price a common stock relative to yesterday s price or relative to today s price comparable securities Investors generally take yesterday s price as correct adjusting upward or downward on the basis on today s information If information arrives smoothly, then as time passes, investors become increasingly confident that today s price level is correct When investors lose confidence in benchmark of yesterday s price, there may be a period of confused trading and volatile prices before a new benchmark is established V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

39 Limits to arbitrage Definition An arbitrage is an investment strategy that guarantees superior returns without any risk In practice, arbitrage is defined more casually as a strategy that exploits market inefficiency and generates superior returns if and when prices return to fundamental values Such strategies can be very rewarding, but they are rarely risk-free In an efficient market, arbitrageurs buy the underpriced security (pushing up their prices) sells the overpriced securities (pushing their prices down) Arbitrageurs earn profits by buying low, selling high and waiting for prices to converge to fundamentals The arbitrage trading is often called convergence trading V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

40 Limits to arbitrage In practice arbitrage is harder than it looks Trading costs can be significant and some trades difficult to execute For example, suppose you identify an overpriced security that is not in your existing portfolio You want to sell high but how do you sell a stock you don t own? You can borrow shares from an investor s portfolio (the intermediation is made via brokers) You sell the share and then wait until the price falls and you can buy the stock back for less than you sold it for If the stock price increases, sooner or later you will be forced to repurchase the stock at a higher price to return the borrowed share to the lender This is called short-selling V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

41 Limits to arbitrage To short-sell there are costs and fees to be paid The borrower may need to put ut collateral to protect the lender in case prices rise In some cases you will not be able to find shares to borrow The most important limit to arbitrage is the risk that prices will diverge even further before they converge In 1977 Royal Dutch was about 10% below parity A professional money manager may try to arbitrage The first time he could have seen profit on his position was in 1983 In the meantime the mispricing got worse and the manager fired V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

42 Long Term Capital Management (LCTM) LCTM was one of the largest and most profitable hedge funds of the 1990s They believed that interest rates in the different euro zone countries would converge when the euro replaced the countries previous currencies LTCM had taken massive positions to profit from this convergence, as well as massive positions designed to exploit other pricing discrepancies After the Russian government announced a moratorium on some of its debt payments in August 1998, there was great turbulence in the financial markets Many discrepancies that LTCM was betting on suddenly got much larger LTCM was losing hundreds of millions of dollars daily The Federal Reserve Bank of New York took over LTCM s remaining assets and shut down what was left V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

43 The role of hedge funds LTCM s sudden meltdown has not prevented rapid growth in the hedge-fund industry in the 2000s If hedge-funds can push back the limits to arbitrage by avoiding the kinds of problems that LTCM ran into Then markets will be more efficient Asking complete efficiency is probably asking too much Prices can get out of the line and stay out of the line if the risks of an arbitrage strategy outweigh the expected returns V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

44 Behavioral finance Assume for a while that markets are often inefficient How is it possible in a world where a lot of rational and energetic investors stand ready to chase after unusual profit opportunities? A first explanation is that investors have built-in biases and misperceptions that can push prices away from fundamental values Mispricing can be driven by investors psychology People are not 100% rational 100% of the time The field that studies this biases is called behavioral finance V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

45 Attitudes toward risk Psychologists have observed that, when making risky decisions, investors do not focus solely on the current value of their holdings But they look back at whether their investments are showing a profit or a loss This observation is the basis for prospect theory Prospect theory states that the value investors place on a particular outcome is determined by the gains or losses that they have made since the assets was acquired investors are particularly averse to the possibility of even a very small loss and need a high return to compensate for it The pain of loss seems also to depend on whether it comes on the heels of earlier losses Investors may be more prepared to run the risk of a stock market dip after they have enjoyed a run of unexpectedly high returns V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

46 Beliefs about probabilities Psychologists have found that, when judging possible future outcomes, individuals tend to look back at what happened in a few similar situations As a result, investors are led to place too much weight on a small number of recent events For example, an investor might judge that an investment manager is particularly skilled because he has beaten the market for three years in a row investors may consider that three years of rapidly rising prices are a good indication of future profits from investing in the stock market V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

47 Other behavioral biases Most individual are too conservative, i.e., too slow to update their beliefs in the face of new evidence People tend to update their beliefs in the right direction but the magnitude of the change is less than rationality would require Most individual are overcondifent Most investors believe they are better-than-average They also consistently overestimate the odds that the future will turn out as they say and underestimates the chances of unlikely events V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

48 Behavioral Finance Behavioral Finance offers new interpretations of some long-standing puzzles and anomalies Perhaps under-reaction of investors to earnings announcements is due to conservatism On the other hand, it may appear too easy to reach for a psychological text every time we observe phenomena that we cannot explain The usefulness of behavioral finance will depend on whether it can predict mispricing before it is actually observed V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

49 Conclusion The efficient-market hypothesis emphasizes that arbitrage will rapidly eliminate any profit opportunities and drive market prices back to fair value Behavioral-finance specialists concede that there are no easy profits, but argue that arbitrage is costly and sometimes slow-working, implying that deviations from fair value may persist V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

50 The six lessons of market efficiency 1 Markets have no memory 2 Trust market prices 3 Read the entrails 4 There are no financial illusions 5 The do-ti-yourself alternative 6 Seen one stock, seen them all V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

51 Markets have no memory The sequence of past price changes contains no information about future changes Sometimes financial managers seem to act as if this were not the case After abnormal market rise, managers prefer to issue equity rather than debt: they hope to catch the market while it is high They are often reluctant to issue stock after a fall in price: they are inclined to wait for a rebound V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

52 Trust market prices Market prices impound all available information about the value of each security For an investor to achieve consistently superior rates of return, he needs to know more than everyone else The company s assets may also be directly affected by management s faith in its investment skills A company may purchase another simply because its management thinks that the stock is undervalued V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

53 Read the entrails Security prices can tell a lot about (the market perception of) the future If a company s bonds are offering a much higher yield than the average, you can deduce that the firm is probably in trouble Differences between the long-term rate of interest and the short-term rate tells you something about what investors expect to happen to short-term rates in the future V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

54 Read the entrails: an example On September 2001, Hewlett-Packard and Compaq revealed plans to merge Over the following two days the shares of HP underperformed the market by 21% the shares of Compaq underperformed the market by 16% It seems that investors and analysts believed the merger had a negative net present value of $13 billion On November 6, the HP family announced that it would vote against the proposal The next day HP shares gained 16% Price reaction of the two stocks provided a valuable summary of investor opinion about the effect of the merger on firm value It may be the case that management of both firms have had important information that investors lacked V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

55 There are no financial illusions There are occasions on which managers seem to assume that investors suffer from financial illusion Some firms devote considerable ingenuity to the task of manipulating earnings reported to stockholders This can be done by creative accounting by choosing accounting methods that stabilize and increase reported earnings Usually investors don t take the figures at face value V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

56 The do-it-yourself alternative Investors will not pay others for what they can do equally well themselves For example, companies often justify mergers on the grounds that they produce a more diversified and hence more stable firm But investors can hold the stocks of both companies Why should they thank the companies for diversifying It is much easier and cheaper for them to diversify than it is for the firm V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

57 Seen one stock, seen them all Investors don t buy stock for its unique qualities They buy it because it offers the prospect of a fair return for its risk Stocks are almost perfect substitutes The demand for a company s stock should be highly elastic If the prospective return is too low relative to its risk, nobody will want to hold that stock The reverse is true V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

58 Seen one stock, seen them all: Be careful Suppose you want to sell a large block of stocks Since demand is elastic, one would conclude that we need to cut the offering price only very slightly to sell the block However, when you come to sell your stock, other investors may suspect that you want to get rid of it because you know something (negative) they don t Investors will revise their assessment of the stock s value downward Large blocks of stock can be sold close to the market price as long as the seller can convince other investors that he has no private information V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

59 What if markets are not efficient? The previous six lessons rely on the assumption of efficient markets What should financial managers do when markets are not efficient? V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

60 Trading opportunities Suppose the financial staff of a firm notices mispricing in a security The kind of mispricing that a hedge fund would attempt to exploit in a convergence trade Should the financial manager undertake a similar convergence trade? In general the answer is no since the firm has no competitive advantage with respect to trading desks of all the major investment banks and hedge funds An example: Procter & Gamble believed in 1993 that interest rates would be stable and decided to act on this belief to reduce its borrowing costs by taking short positions against Bankers Trust Rates did increase dramatically in early 1994 and P&G lost $102 million V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

61 What if a company s shares are mispriced The strong form of market efficiency does not always hold Financial manager will often have special information that outside investors do not have Investors may be slow in reacting to an information or may be infected with behavioral biases V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

62 What if a company s shares are mispriced If the company s shares are overpriced The financial manager can help current shareholders by selling additional stock and using the cash to invest in other capital market securities If the company s shares are underpriced Financial managers may be justifiably reluctant to issue more stock in order to finance an investment program They can alternatively issue debt or forego the opportunity to invest V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

63 What if a company s shares are mispriced If the company is caught in a bubble True bubbles are rare and hard to detect Financial management poses difficult personal and ethical challenges Managers are tempted to cover up bad news or manufacture good news especially when bonuses and stock-options payoffs depend on stock prices However, when bubble burst, there may be lawsuits and jail time for managers who have resorted to tricky accounting have misleading public statements in an attempt to sustain the inflated stock price V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

64 Question The strong-form of the efficient-market hypothesis is nonsense. Look at mutual fund X; it has had superior performance for each of the last 10 years. Does the speaker have a point? V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

65 Question Suppose that there is a 50% probability that X will obtain superior performance in any year simply by chance If X is the only fund, calculate the probability that it will have achieved superior performance for each of the past 10 years = Now recognize that there are over 10,000 mutual funds in the United States. What is the probability that by chance there is at least 1 out of 10,000 funds that obtained 10 successive years of superior performance? The probability that, out of 10,000 mutual funds, none of them obtained ten successive years of superior performance is: ( ) 10,000 = Therefore, the probability that at least one of the 10,000 mutual funds obtained ten successive years of superior performance is: = V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

66 Question Suppose that there is a 50% probability that X will obtain superior performance in any year simply by chance If X is the only fund, calculate the probability that it will have achieved superior performance for each of the past 10 years = Now recognize that there are over 10,000 mutual funds in the United States. What is the probability that by chance there is at least 1 out of 10,000 funds that obtained 10 successive years of superior performance? The probability that, out of 10,000 mutual funds, none of them obtained ten successive years of superior performance is: ( ) 10,000 = Therefore, the probability that at least one of the 10,000 mutual funds obtained ten successive years of superior performance is: = V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

67 Question Suppose that there is a 50% probability that X will obtain superior performance in any year simply by chance If X is the only fund, calculate the probability that it will have achieved superior performance for each of the past 10 years = Now recognize that there are over 10,000 mutual funds in the United States. What is the probability that by chance there is at least 1 out of 10,000 funds that obtained 10 successive years of superior performance? The probability that, out of 10,000 mutual funds, none of them obtained ten successive years of superior performance is: ( ) 10,000 = Therefore, the probability that at least one of the 10,000 mutual funds obtained ten successive years of superior performance is: = V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65

68 Question Suppose that there is a 50% probability that X will obtain superior performance in any year simply by chance If X is the only fund, calculate the probability that it will have achieved superior performance for each of the past 10 years = Now recognize that there are over 10,000 mutual funds in the United States. What is the probability that by chance there is at least 1 out of 10,000 funds that obtained 10 successive years of superior performance? The probability that, out of 10,000 mutual funds, none of them obtained ten successive years of superior performance is: ( ) 10,000 = Therefore, the probability that at least one of the 10,000 mutual funds obtained ten successive years of superior performance is: = V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 65