CORPORATE FINANCE DECISION

1. CHAPTER
14
Corporate Financing Decisions
and Efficient Capital Markets

2. Can Financing Decisions Create Value?
Typical financing decisions include:
• How much debt and equity to sell
• When (or if) to pay dividends
• When to sell debt and equity
Just as NPV criteria can be used to evaluate capital
investment decisions, the same can be used to evaluate
financing decisions.

3. How to Create Value through Financing
There are basically three ways to create valuable
financing opportunities:
1. Fool Investors
∙ A firm can raise capital in different ways such as by
issuing stocks or by issuing complex securities e.g. a
combination of warrants and stock. It is assumed that
100 shares of stock worth the same as 50 units of the
complex security. If investors have misguided overly
optimistic view regarding the complex security, then
the complex securities may be sold for more than
the value of 100 shares i.e. the fair market value. In
this case, the complex securities are providing
valuable financing opportunities.

4. How to Create Value through Financing
Finance managers attempt to package securities to
receive the greatest value. However, the theory of
efficient capital market implies that securities are
appropriately priced all the times and consequently
investors can not be easily fooled. Therefore,
corporate managers cannot attempt to create value by
fooling investors instead they must create value in
other ways.
2. Reduce Costs or Increase Subsidies
∙ Certain forms of financing have greater tax advantages
or carry other subsidies. A firm can create value by
packaging securities that minimize taxes or other costs
such as fees paid to investment bankers, lawyers,

5. How to Create Value through Financing
accountants etc. For example, if a firm can avail
subsidized rate financing, it will certainly create value.
3. Create a New Security
∙ There has been a surge in financial innovation in
recent years. Once corporations only used to issue
straight bonds and stocks, they now issue zero-coupon
bonds, adjustable-rate notes, floating-rate bonds,
putable bonds, callable bonds, convertible preferred
stock, adjustable-rate convertible notes, etc. As such, a
previously-unsatisfied group of investors now willing
to pay extra for a specialized security catering to their
needs. For example, putable bonds let the purchaser

6. How to Create Value through Financing
sell the bond at a fixed price back to the firm. This
innovation creates a price floor and reduces
downside risk and is particularly suitable for risk-
averse investors. Corporations gain by issuing these
unique securities at high prices.
However, in the long-run this value creation is
relatively small as the innovator usually can not
patent or copyright his or her idea.

7. A Description of Efficient
Capital Markets
An efficient capital market is one in which stock
prices fully reflect available information.
In an efficient capital market any price sensitive
information almost immediately reflects in the
security prices. Therefore, it is difficult for the investors
to gain from knowing the price sensitive information as
it has already incorporated in the security prices when
they come to know about it.

8. A Description of Efficient
Capital Markets
The EMH has the following implications for the
investors and firms.
• Since information is reflected in security prices quickly,
knowing information when it is released does an
investor no good. The price gets adjusted before the
investor has time to trade on it.
• Firms should expect to receive the fair value for the
securities that they sell. Therefore, firms cannot profit
from fooling investors in an efficient market.

9. A Description of Efficient
Capital Markets
The following graph shows several possible adjustments in
stock prices. The solid line indicates 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 broken and dotted lines depict a delayed reaction and
overreaction respectively to the new information. Both the
lines show the possible scenario in an inefficient capital
market.
For example, if it takes several days to adjust the security
prices, the investor gets enough time to make trading profit.

10. Reaction of Stock Price to New Information in
Efficient and Inefficient Markets
Stock
Price
-30 -20 -10 0 +10 +20 +30
Days before (-) and
after (+) announcement
Efficient market
response to “good news”
Overreaction to “good
news” with reversion
Delayed
response to
“good news”

11. Reaction of Stock Price to New Information in
Efficient and Inefficient Markets
Stock
Price
-30 -20 -10 0 +10 +20 +30
Days before (-) and
after (+) announcement
Efficient market
response to “bad news”
Overreaction to “bad
news” with reversion
Delayed
response to
“bad news”

12. Foundations of Markets Efficient
There are three conditions of market efficiency, these are
rationality, independent deviation from rationality, and
arbitrage. Any of the three conditions can make the
market efficient.
Rationality: If all investors in the market are rational,
then they would react almost the same way to any new
price sensitive information released in the marketplace. As
such, the prices in the efficient capital market will adjust .
The rational investors would have no reason to wait for
trading at the new prices.
However, in real life we rarely see all investors to be
rational. Nevertheless, the market will still be efficient if
the following scenario prevails.

13. Foundations of Markets Efficient
Independent Deviation from Rationality: It is pragmatic
to assume that all investors in the market will not react the
same way to any new price sensitive information released
in the marketplace. Some investors may response
optimistically (more than rational) to the new information
and as such will be willing to buy or sell shares at a higher
price than that would have been under efficient market.
Whereas, others may be willing to trade below the price of
efficient market because of pessimistic view (less than
rational) about the new information. Due to the above two
opposing forces, prices will be settled at the efficient
market prices. Therefore, market efficiency will be
restored.
However, the assumption of offsetting of the two opposing
forces at all times may be unrealistic. Perhaps, at certain

14. Foundations of Markets Efficient
times most investors may be overly optimistic and at other
times, may be very pessimistic. But, even then there is an
assumption that will produce market efficiency.
Arbitrage: Considering two groups of investors - one is
rational and the other is irrational. The irrational group,
by mistake, at times think irrationally that a stock is
undervalued and at other times believe the opposite. If
the two opposing beliefs do not offset each other, then this
group will tend to hold stocks either above or below the
efficient market prices.

15. Foundations of Markets Efficient
On the other hand, the rational group will perform all
types of analysis and determine which stocks are under
priced and which stocks are overpriced. They will, if
necessary, rearrange their entire portfolio. If their portfolio
includes stocks that are overpriced, they will sell them and
if they could identify similar types of stocks that are under
priced, they will buy them. This act of buying and selling
of different but substitute securities in order to make
profit is known as arbitrage. If the arbitrage of rational
group dominates the speculation of the irrational
group, markets would still be efficient.

16. The Different Types of Efficiency
In reality, stock prices are influenced by some
information more than others. Therefore, the stock
prices do not respond the same way to different price
sensitive information.
On the basis of the information that affects the stock
prices, three types of classifications are made:
information on past prices, publicly available
information, and all information.
The impact of the three information-sets on stock prices
is examined next:

17. Weak Form Market Efficiency
Security prices reflect all information found in past
prices and volume. A capital market is said to be weakly
efficient or satisfies a weak-form efficiency if it fully
incorporates the information regarding past stock prices.
If the weak form of market efficiency holds, then technical
analysis is of no value.
Often weak-form efficiency is represented as
Pt = Pt-1 + Expected return + random error t
The above equation states that the price today is equal to
the last observed price plus the expected return on the
stock plus a random component occurring over the
interval.

18. Weak Form Market Efficiency
The interval can be last week or last month or last quarter
etc. The expected return is a function of the security’s
risk, and the random component is due to new
information on the stock. It could be either negative or
positive or zero. The random component of one time
period is not related to the random component of other
time period. Thus, it is not predictable from the past
prices. Since, the stock prices only respond to new
information, which by definition arrives randomly, stock
prices are said to follow a random path.

19. Why Technical Analysis Fails
Stock
Price
Time
Investor behavior tends to eliminate any profit
opportunity associated with stock price patterns.
If it were possible to make
big money simply by
finding “the pattern” in
the stock price movements,
everyone would do it and
the profits would be
competed away.
Sell
Sell
Buy
Buy

20. Semi-Strong Form Market Efficiency
A market is semi-strong form efficient if security prices
reflect (incorporate) all publicly available information.
Publicly available information includes:
• Historical (past) price and volume information
• Published accounting statements.
• Information found in annual reports.

21. Strong Form Market Efficiency
Security Prices reflect all information—public and
private.
Strong form efficiency incorporates weak and
semi-strong form efficiency.
Strong form efficiency says that anything pertinent
to the stock and known to at least one investor is
already incorporated into the security’s price.

22. Relationship among Three Different Information Sets
All information
relevant to a stock
Information set
of publicly available
information
Information
set of
past prices

23. Some Common Misconceptions
Much of the criticism of the EMH is based on a
misunderstanding of what the hypothesis says and does
not say. Three misconceptions have been illustrated
below:
The Efficacy of Dart Throwing: The efficient market
hypothesis implies that managers, on average, will not be
able to achieve abnormal or excess return. It further
says, the price that a firm obtains from selling shares is a
fair price i.e. the price reflects the value of the stock on
the basis of the available information. Therefore,
shareholders need not worry about the price they are
paying or getting from trading stocks. However, they
have to think about the level of risk and the extent of
diversification.

24. Some Common Misconceptions
Price Fluctuations: The investors are doubtful about
market efficiency because prices of stock fluctuate day
to day. However, daily price movement is in no way
inconsistent with market efficiency; a stock in an
efficient market adjusts to new information by changing
price. Lot of price sensitive information comes into the
stock market each day. In fact, absence of daily price
movement in a changing world may imply inefficiency.
Stockholder Disinterest: Many laypeople are doubtful
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 if the price of a particular stock reaches to that
level which justifies incurring brokerage fees, transaction

25. Some Common Misconceptions
costs etc. A stock is expected to be efficiently priced as
long as number of interested traders use the publicly
available information. Stock prices still reflect the
available information even if many stockholders never
follow the stock and are not considering trading in the
near future.

26. Implications for Corporate Finance
The EMH has three implications for
corporate finance:
1. The price of a company’s stock cannot be affected
by a change in accounting.
2. Financial managers cannot “time” issues of stocks
and bonds using publicly available information.
3. A firm can sell as many shares of stocks or bonds as
it desires without depressing prices.