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Chapter13: Corporate Financing Decisions and Efficient Capital Markets

13.8 Implications for Corporate Finance

So far this chapter has examined both theoretical arguments and empirical evidence concerning efficient markets. We now ask whether market efficiency has any relevance for corporate financial managers. The answer is that it does. Next we consider four implications of efficiency for managers.

Accounting Choices, Financial Choices, and Market Efficiency

The accounting profession provides firms with a significant amount of leeway in their reporting practices. Managers clearly prefer high share prices to low share prices. Should managers use the leeway in accounting choices to report the highest possible income? Not necessarily. That is, accounting choice should not affect share price if two conditions hold. First, enough information must be provided in the annual report so that financial analysts can construct earnings under the alternative accounting methods. This appears to be the case for many, though not necessarily all, accounting choices. Second, the market must be efficient in the semi-strong form. In other words, the market must use all of this accounting information appropriately in determining the market price.

Of course, the issue of whether accounting choice affects share price is ultimately an empir-ical matter. A number of academic papers have addressed this issue. Kaplan and Roll found that the switch from accelerated to straight-line depreciation did not affect share prices.17

Several other accounting procedures have been studied. Hong, Kaplan and Mandelker found no evidence that the stock market was affected by the artificially higher earnings reported using the pooling method, compared with the purchase method, for reporting mergers and acquisitions.18 In summary, empirical evidence suggests that accounting changes do not fool the market. Therefore the evidence does not suggest that managers can boost share price through accounting practices. In other words, the market appears efficient enough to see through different accounting choices.

One caveat is called for here. Our discussion specifically assumed that ‘financial analysts can construct earnings under the alternative accounting methods’. However, companies such as Enron, WorldCom, Global Crossing, Parmalat and Xerox simply reported fraudulent numbers in recent years. There was no way for financial analysts to construct alternative earnings numbers, because these analysts were unaware how the reported numbers were determined. So it was not surprising that the share prices of these companies initially rose well above fair value. Yes, managers can boost prices in this way - as long as they are willing to serve time in prison once they are caught!

The Timing Decision

Imagine a firm whose managers are contemplating the date to issue equity. This decision is frequently called the timing decision. If managers believe that their equity is overpriced, they are likely to issue shares immediately. Here, they are creating value for their current shareholders because they are selling shares for more than they are worth. Conversely, if the managers believe that their equity is underpriced, they are more likely to wait, hoping that the equity price will eventually rise to its true value.

However, if markets are efficient, securities are always correctly priced. Efficiency implies that equity is sold for its true worth, so the timing decision becomes unimportant. Figure 13.13 shows three possible share price adjustments to the issuance of new equity.

Figure 13.13Three share price adjustments after issuing equity
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Ritter presents evidence that annual equity returns over the five years following an initial public offering (IPO) are about 2 per cent less for the issuing company than the returns on a non-issuing company of similar book-to-market ratio.19 Annual share price returns over this period following a seasoned equity offering (SEO) are between 3 per cent and 4 per cent less for the issuing company than for a comparable non-issuing company. A company’s first public offering is called an IPO and all subsequent offerings are termed SEOs. The upper half of Fig. 13.14 shows average annual returns of both IPOs and their control group, and the lower half of the figure shows average annual returns of both SEOs and their control group.

Figure 13.14Returns on initial public offerings (IPOs) and seasoned equity offerings (SEOs) in years following issue
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The evidence in Ritter’s paper suggests that corporate managers issue SEOs when the company’s equity is overpriced. In other words, managers appear to time the market successfully. The evidence that managers time their IPOs is less compelling: returns following IPOs are closer to those of their control group.

Does the ability of a corporate official to issue an SEO when the security is overpriced indicate that the market is inefficient in the semi-strong form or the strong form? The answer is actually somewhat more complex than it may first appear. On the one hand, officials are likely to have special information that the rest of us do not have, suggesting that the market need only be inefficient in the strong form. On the other hand, if the market were truly semi-strong efficient, the price would drop immediately and completely upon the announcement of an upcoming SEO. That is, rational investors would realize that equity is being issued, because corporate officials have special information that the shares are overpriced. Indeed, many empirical studies report a price drop on the announcement date. However, Fig. 13.13 shows a further price drop in the subsequent years, suggesting that the market is inefficient in the semi-strong form.

If firms can time the issuance of shares, perhaps they can also time the repurchase of shares. A firm would like to repurchase when its equity is undervalued. Ikenberry, Lakonishok and Vermaelen find that equity returns of repurchasing firms are abnormally high in the two years following repurchase, suggesting that timing is effective here.20

Speculation and Efficient Markets

We normally think of individuals and financial institutions as the primary speculators in financial markets. However, industrial corporations speculate as well. For example, many companies make interest rate bets. If the managers of a firm believe that interest rates are likely to rise, they have an incentive to borrow, because the present value of the liability will fall with the rate increase. In addition, these managers will have an incentive to borrow long-term rather than short-term in order to lock in the low rates for a longer period. The thinking can get more sophisticated. Suppose that the long-term rate is already higher than the short-term rate. The manager might argue that this differential reflects the market’s view that rates will rise. However, perhaps he anticipates a rate increase even greater than what the market anticipates, as implied by an upward-sloping term structure. Again, the manager will want to borrow long-term rather than short-term.

Firms also speculate in foreign currencies. Suppose that the CFO of a multinational cor-poration based in the United Kingdom believes that the euro will decline relative to sterling. She would probably issue euro-denominated debt rather than sterling-denominated debt, because she expects the value of the foreign liability to fall. Conversely, she would issue debt domestically if she believes foreign currencies will appreciate relative to the British pound.

We are perhaps getting a little ahead of our story: the subtleties of the term structure and exchange rates are treated in other chapters, not this one. However, the big question is this: What does market efficiency have to say about such activity? The answer is clear. If financial markets are efficient, managers should not waste their time trying to forecast the movements of interest rates and foreign currencies. Their forecasts will probably be no better than chance. And they will be using up valuable executive time. This is not to say, however, that firms should flippantly pick the maturity or the denomination of their debt in a random fashion. A firm must choose these parameters carefully. However, the choice should be based on other rationales, not on an attempt to beat the market. For example, a firm with a project lasting five years might decide to issue five-year debt. A firm might issue renminbi-denominated debt because it anticipates expanding into China in a big way.

The same thinking applies to acquisitions. Many corporations buy up other firms because they think these targets are underpriced. Unfortunately, the empirical evidence suggests that the market is too efficient for this type of speculation to be profitable. And the acquirer never pays just the current market price. The bidding firm must pay a premium above market to induce a majority of shareholders of the target firm to sell their shares. However, this is not to say that firms should never be acquired. Rather, managers should consider an acquisition if there are benefits (synergies) from the union. Improved marketing, economies in production, replacement of bad management, and even tax reduction are typical synergies. These synergies are distinct from the perception that the acquired firm is underpriced.

One final point should be mentioned. We talked earlier about empirical evidence suggesting that SEOs are timed to take advantage of overpriced equity. This makes sense - managers are likely to know more about their own firms than the market does. However, while managers may have special information about their own firms, it is unlikely that they have special information about interest rates, foreign currencies, or other firms. There are simply too many participants in these markets, many of whom are devoting all of their time to forecasting. Managers typically spend most of their effort running their own firms, with only a small amount of time devoted to studying financial markets.

Information in Market Prices

The previous section argued that it is quite difficult to forecast future market prices. However, the current and past prices of any asset are known - and of great use. Consider, for example, Becher’s study of bank mergers.21 The author finds that share prices of acquired banks rise about 23 per cent on average upon the first announcement of a merger. This is not surprising, because companies are generally bought out at a premium above current share price. However, the same study shows that prices of acquiring banks fall almost 5 per cent on average upon the same announcement. This is pretty strong evidence that bank mergers do not benefit, and may even hurt, acquiring companies. The reason for this result is unclear, though perhaps acquirers simply overpay for acquisitions. Regardless of the reason, the implication is clear. A bank should think deeply before acquiring another bank.

Furthermore, suppose you are the CFO of a company whose share price drops much more than 5 per cent upon announcement of an acquisition. The market is telling you that the merger is bad for your firm. Serious consideration should be given to cancelling the merger, even if, prior to the announcement, you thought the merger was a good idea.

Of course, mergers are only one type of corporate event. Managers should pay attention to the share price reaction to any of their announcements, whether it concerns a new venture, a divestiture, a restructuring, or something else.

This is not the only way in which corporations can use the information in market prices. Suppose you are on the board of directors of a company whose share price has declined precipitously since the current chief executive officer (CEO) was hired. In addition, the prices of competitors have risen over the same time. Though there may be extenuating circumstances, this can be viewed as evidence that the CEO is doing a poor job. Perhaps he should be fired. If this seems harsh, consider that Warner, Watts and Wruck find a strong negative correlation between managerial turnover and prior stock performance.22 Figure 13.15 shows that share prices fall on average about 40 per cent in price (relative to market movements) in the three years prior to the forced departure of a top manager.

Figure 13.15Share price performance prior to forced departures of management
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Market efficiency implies that share prices reflect all available information. We recommend using this information as much as possible in corporate decisions as long as the manager feels that share prices accurately reflect the true value of company equity. In most emerging-market countries stock markets may not be very efficient, and you should be careful about using available share prices. In developed economies, at least with respect to executive firings and executive compensation, it looks as if real-world corporations do pay attention to market prices. The following box summarizes some key issues in the efficient markets debate:

Efficient Market Hypothesis: A Summary

Does not say:

  1. Prices are uncaused.

  2. Investors are foolish and too stupid to be in the market.

  3. All shares of equity have the same expected returns.

  4. Investors should throw darts to select shares.

  5. There is no upward trend in share prices.

Does say:

  1. Prices reflect underlying value.

  2. Financial managers cannot time equity and bond sales.

  3. Managers cannot profitably speculate in foreign currencies.

  4. Managers cannot boost share prices through creative accounting.

Why doesn’t everybody believe it?

  1. There are optical illusions, mirages, and apparent patterns in charts of stock market returns.

  2. The truth is less interesting.

  3. There is evidence against efficiency:

    1. Two different, but financially identical, classes of shares of the same firm selling at different prices.

    2. Earnings surprises.

    3. Small versus large company share price returns.

    4. Value versus growth stocks.

    5. Crashes and bubbles.

Three forms

Weak form: Current prices reflect past prices; chartism (technical analysis) is useless.

Semi-strong form: Prices reflect all public information; most financial analysis is useless.

Strong form: Prices reflect all that is knowable; nobody consistently makes superior profits.

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