Chapter 13: Corporate-Financing Decisions and Efficient Capital Markets

13.1 a. Firms should accept financing proposals with positive net present values (NPVs).
b. Firms can create valuable financing opportunities through the use of subsidies and
inside information, or by lowering their transaction costs.

13.2
Weak form: Prices reflect all information contained in historical data.
Semi-strong form: In addition to historical data, prices reflect all publicly available
information.
Strong form: Prices reflect all information, public or private.

13.3 a. False: Market efficiency implies prices reflect all available information, but it does
not imply certain knowledge. Many pieces of information that are available and
reflected in prices are somewhat uncertain. Efficiency of markets does not eliminate
that uncertainty and therefore does not imply perfect forecasting ability.

b. True: Market efficiency exists when prices reflect all available information. To be
weak form efficient, the market must incorporate all historical data into prices.
Under the semi-strong form of the hypothesis, the market incorporates all publicly
available information in addition to the historical data. In a strong form efficient
market, prices reflect all publicly and privately available information.

c. False: Market efficiency implies that market participants are rational. Rational
people will immediately act upon new information and they will bid prices up or
down to reflect that information.

d. False: Since in efficient markets prices reflect all available information, prices will
fluctuate whenever new information becomes available.

e. True: Without competition among investors, information could not be readily

13.4
a. Aerotechs stock price should rise immediately after the announcement of this positive
news.
b. Only scenario ii (the stock price jumps to $116 and remains there) indicates market
efficiency. In that case, the price rose immediately to the level that eliminated all
possibility of abnormal returns. In the other two scenarios, there are periods of time
during which an investor could trade on the information and earn abnormal returns.

13.5 False. In an efficient market, the stock price would have adjusted before the founders death
only if investors had perfect forecasting ability. The 12.5% increase in the stock price after
the founders death indicates that either the market did not anticipate the death or it
anticipated it imperfectly. Since the market reacted to new information, it was efficient. It is
interesting that the stock rice rose after the announcement of the founders death. This price
behavior indicates that the market felt he was a liability to the firm.

13.6 Investors should not be deterred from buying UPCs stock because of the announcement. If
the market is at least semi-strong form efficient, the stock price will have already reflected
 the present value of the payments that UPC must make. Buying the stock at the post-
announcement price should provide the same return that the stock was providing before the
announcement. (NOTE: UPCs current stockholders bear the burden of the loss. At the time
of the announcement, returns would have been abnormally low. After the information was
incorporated into the price, returns are normal again.)

13.7 The market is generally considered to be efficient up to the semi-strong form, which means
that no systematic profit can be made by trading on publicly available information. The lead
engineer of the device can profit from purchasing the firms stock before the news release on
the implementation of the new technology because she can trade on insider information. As
the information on the new technology becomes publicly available, nobody can profit from
rushing into the stock market based on Wall Street Journal articles.

13.8 Given that semi-strong form of market efficiency holds approximately in the real world, the
stock price should stay the same. The accounting system changes are publicly available
information. The investors would know that in essence, there is no change in the operational,
and the financial state of the firms current and future cash flows. So the stock price will not
change after the announcement of increased earnings.

13.9 No, Alex cannot make money by investing in firms that just issued public stock based on the
fact that these firms performed better than others. If they are considered better performing
firms, the markets expectation of their current and future cash flows would already have
been raised to a higher level and reflected in the current stock prices. No abnormal profit
can be made since the purchasing prices of the stocks would have already been
commensurate with the higher expected earning powers.

13.10 Because the number of subscribers has increased dramatically, the time it takes for
information in the newsletters to be reflected in prices has shortened. With shorter adjustment
periods, it becomes impossible to earn abnormal returns with the information provided by
Sooners.

13.11 You should not agree with your broker. The performance ratings of the small manufacturing
firms were published, and therefore, public information. An efficient market would
incorporate that information into the prices of the firms shares such that abnormal returns
could not be reaped. Indeed, in an efficient market you should not expect these firms to earn
above-average returns.

13.12 By the time the Wall Street Journal comes out, the stock price reaction would have already
taken place. Since semi-strong form of market efficiency holds, nobody can systematically
profit from this publicly available information.

13.13 Technical analysis is not consistent with EMH. Technical analysts cant systematically
profit from trading rules based on historical stock prices. If technical analysts can
systematically profit from trading rules based on patterns in the historical stock price, then
weak form of market efficiency is violated.

13.14 One explanation given to the 1987 market crash and the high price to earnings ratio of
Japanese market is the bubble theory. It tries to interpret the deviation from EMH by the
fluctuation of investor sentiments and psychology. Namely, the fluctuation in investor
sentiments and psychology lead to abnormal prices.
13.15 a. In an efficient market, the CAR for Prospectors would rise substantially at the
announcement of a new discovery. Then it should remain constant until the next
discovery.
b. As long as there is no relationship between the discovery of one vein and another, the
CAR is a random walk.
c. The behavior of Prospectors CAR is consistent with market efficiency. Although the
market knows the miners will eventually find another vein, it does not incorporate the
increase in value into the stock price until the announcement is made.

13.16 Abnormal Return (Ri - Rm):

Average Cumulative
Days from abnormal average
announcement Delta United Pan Am Sum return residual
-4 -0.2 -0.2 -0.2 -0.6 -0.2 -0.2
-3 0.2 -0.1 0.2 0.3 0.1 -0.1
-2 0.2 -0.2 0.0 0.0 0.0 -0.1
-1 0.2 0.2 -0.4 0.0 0.0 -0.1
0 3.3 0.2 1.9 5.4 1.8 1.7
1 0.2 0.1 0.0 0.3 0.1 1.8
2 -0.1 0.0 0.1 0.0 0.0 1.8
3 -0.2 0.1 -0.2 -0.3 -0.1 1.7
4 -0.1 -0.1 -0.1 -0.3 -0.1 1.6

2
1.8 1.8
1.7 1.7
CAR

1.5

0.5

0 -0.1 -0.1 -0.1

Days from announcement

The market reacts favorably to the announcements of acquisition of new planes. Moreover, it
reacts only on the day of the announcement. Before and after the event, the CARs are
relatively flat and they jump only on the day of the event. This CAR behavior demonstrates
market efficiency.
13.17 This diagram does not support the efficient markets hypothesis. After the announcement of a
discovery, the CAR should remain relatively flat at the level it attained on the event day.

13.18 The diagram is not consistent with the efficient markets hypothesis (EMH). The diagram is
consistent with the EMH through the event day. After the announcement of the court
decision, the CAR declines which would allow investors to earn undue returns. As facts
about the case are released during the litigation, returns may fluctuate. Once the case is
resolved, such price behavior should stop. Thus, the CAR should remain constant even if an
appeal is in progress.

13.19 Figure A: Supports - Until day zero, the CAR was falling due to the release of negative
information. After the event the CAR is constant.

Figure B: Supports - Again returns are not moving up or down after the event.

Figure C: Rejects - Because returns increase after the event date, it is possible to formulate
advantageous trades. Such possibilities are inconsistent with the efficient
markets hypothesis.

Figure D: Supports - the diagram indicates that the information was of no value.

13.20 The scenario depicts a case in which the knowledge that the marketable securities were worth
more than the market value of Kennecott Copper was not public. It was not until Arco
purchased Kennecott that the information became public. (Kennecott managers may even
have been unaware of the situation.) Since no public information was available about the
securities values, semi-strong form efficiency is not in doubt. Also, it is possible that other
Kennecott assets had negative NPVs that outweighed the positive value of the marketable
securities.

13.21 a. No. Earnings information is in the public domain and therefore, reflected in the
current stock price.
b. Possibly. If the rumors were publicly disseminated, the prices would have already
accounted for the probability of a merger. If the rumor is information that you got
from an insider, you could earn excess returns, but clearly, trading on that
information is illegal.
c. No. Again, the information is already public.

13.22 Your stock price changes should not be serially correlated. If the market is efficient, the
information about the serial correlation in the macroeconomic variable and its relationship to
the stock price should already be reflected in the stock price. Remember, correlation of
pieces of information is information itself !

13.23 The statement is false because every investor has different risk preference. Although the
expected return from every well-diversified portfolio is the same after adjusting for the risk,
investors still need to choose funds that are consistent with their particular risk level to
invest.
13.24 a. There are mixed empirical findings concerning price pressure of block trading. On
the one hand, Scholes found that there is no price pressure effect. On the other hand,
Kraus and Stoll found clear evidence of price pressure effects although the effects
were very small. Practitioners generally believe that the sale of large blocks of shares
can temporarily depress the price of a companys stock.
b. It might be a good idea for the block seller to break a very large block into several
lots to reduce a potentially large price pressure effect.
c. If the EMH holds, the expected price effect will be zero.