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The Six Lessons of Market Efficiency
Lesson 1: Markets have no memory (don't wait for recent price changes to be reversed; they probably will not be)
Lesson 2: Trust market prices (more than your own hunches)
Lesson 3: Look at market prices in detail to predict the future (term structure; market's unfavorable assessment of Viacom's takeover of Paramount); for the market price implicitly weights a lot of people's serious assessments
Viacom takeover of Paramount--an abnormal return of -40% in the six months between the announcement of the initial bid and the acceptance of the final bid.
Lesson 4: Do not believe in financial illusions (dividends and stock splits; stock prices run up before a split)
During the year subsequent to a split, two-thirds of the splitting companies announced above-average increases in cash dividends (and earnings); indeed, the stocks of companies that did not increase their dividends declined in value to levels prevailing well before the split. The apparent explanation is that the split is an implicit promise of good accounting and dividend news to come soon...
Lesson 5: Value is lost when the company does something that a shareholder can do on his own for smaller transaction costs
Whenever a firm leverages up, the question the Treasurer should wonder is: can the firm leverage itself up more cheaply than the individual shareholder can increase the beta of his or her portfolio.
Lesson 6: Demands for stocks should be highly, highly elastic.
British Petroleum privatization--$970 million in 1977 sold off. Offered at 845 pence each, market price at close of offer some 898 pence--a 6% discount. Demand for BP stock equal to 4.7 times the amount sold. The stock market can absorb enormous amounts of stock, if people are focused on the sale (and are sure it doesn't carry any "fundamental" news).
Note that the efficient markets hypothesis does not mean that the financing of a corporation will "take care of itself"; it provides a starting point, not an ending point, for analyis.
Possible quiz: Suppose that you have spent a week researching the business prospects of Apple Computer (it closed at $25 5/8 yesterday). Suppose that your research suggests a stock price of $40. Using both pieces of information--your research and the market price--what is your best guess of the value of Apple Computer stock? Which source of information did you weight more heavily? Why?
Enormous variety of financing instruments
International Paper's debt securities (and equity) at the end of 1993:
9.4% to 9.7% notes due 1995-2002
7 5/8% notes due 2004, 2023
6 1/8% notes due 2003
6 7/8% notes due 2023
Assorted medium-term notes due 1994-2006
9 1/8% French franc notes due 1994
5 1/8% debentures due 2012
5 1/4% euro-convertible subordinated debentures due 2002
Environmental and industrial development bonds
Other franc borrowoing
German mark borrowing
Equity Book Value
Issued common shares (at par)
Treasury shares (at cost)
Net common equity
Maximum number of shares; shares that are issued and outstanding; repurchased shares that are issued but not outstanding--the Carter Investment Corp. currently has 64. Shares entered at "par" value--originally a protection of shareholders against insiders: couldn't sell to insiders for less than "par". Today"par" almost always $1. Premium of isue price over par is "additional capital" or "paid-in surplus". Retained earnings. Payouts of capital (for Treasury shares).
Net book value--different from market value. Tobin's q.
Stockholders; majority voting; cumulative voting;
Equity in disguise: "limited" partners, REITs, "Royalty Trust"
Debt--can't vote, but interest is paid out of before tax income; and have rights to throw company into bankruptcy.
funded debt--greater than one year maturity. Walt Disney has issued 100-year bonds. NatWest has issued "perpetuities".
unfunded debt--less than one year
commercial paper--usually backed by a bank "line of credit"; other uses of lines of credit.
Sinking fund--for gradual repurchase of bonds
Call--right to buy debt back at principal value. Typically five years of "call protection"
Senior debt/subordinated debt
Secured debt; default risk; investment-grade--one of the top four ratings. "Fallen angels". New junk bond issues
Public issue vs. private placement.
Floating versus fixed rates. London Interbank Offered Rate; eurobonds; eurodollars.
Leased equipment--looks a lot like debt;
Preferred stock--a security that lacks the voting rights of common stock, and that lacks the bankruptcy protection rights of debt; rarely issued save by public utilities which want to have a high nominal capital base.
Convertibles; a warrant--nothing but an option to buy a certain number of common shares from the Treasury at a set price on or before a set date. Convertible bond--a package of a corporate bond and a warrant
Traded options; Chicago Board of Trade Options Exchange
Futures--an order you place in advance to buy or sell at a fixed price at some future date. Hillary Rodham Clinton.
Forward--a tailor-made future contractnot traded on an exchange.
Swap--currency swaps, or interest rate swaps... All these can be ways to hedge specific risks that threaten the corporation (why should a corporation worry about idiosyncratic risk? It should worry if it affects return--costs of bankruptcy, for example).
Why so much innovation? Taxes and financial regulations are very important causes; a belief that wide investor choice is good for its own sake. But in a pure CAPM world there would be much, much, much less variety of securities.
Patterns of corporate financing.
Heavy reliance on internal financing...
Debt-to-market ratios vary between 11% and 36% across industrial economies.
Dispersal of ownership; free-rider problem; managerial displacement via voting-with-the-feet and takeover threat; managerial displacement via directors' coup; agency problems created by separation of ownership and control offset by (i) rights issues provided to top managers (less than perfect); (ii) fear of lawsuits; (iii) threat of takeover.
alternative systems--bank representatives on boards of directors; large voting blocks; universal banking; "keiretsu"
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