Corporate Finance - One Flashcards
What is the Efficient Markets Hypothesis (EMH)?
At all times, a security’s market price reflects the true, rational value of the security - fairly priced.
What is the Weak Form of market efficiency?
Price reflects all information contained in historical prices (identify mispricing with technical analysis).
What is the Semi-Strong Form of market efficiency?
Price reflects all public information (identify mispricing with fundamental analysis).
What is the Strong Form of market efficiency?
Price reflects all information, public and private (insiders earn abnormal returns).
What is the paradox of market efficiency?
If the market is already efficient with respect to the information gathered, investors will not benefit from engaging in costly security analysis, but the market can’t be efficient if no one gathers info. The market cannot be absolutely efficient because prices deviate from true values.
What is the Random Walk Hypothesis?
Cannot use past price movement to predict future price movement because stocks follow a random pattern, which is evidence against weak form.
What is the rationale behind an Event Study?
Based on semi-strong efficiency. As new info about a firm arrives, the market price of the firm’s stock should immediately and unbiasedly change to reflect this information.
What are examples of value-relevant information?
- Government Press Release
- Earnings Announcement
- Dividends and Stock Repurchases
- Investment
- External Financing (debt vs. equity)
- Merger or acquisition.
How do prices react to new good news?
Overreaction to ‘good news’ with reversion or delayed response to ‘good news’ vs. EMH increase on day 0.
How do prices react to new bad news?
Overreaction to ‘bad news’ with reversion or delayed response to ‘bad news’ vs. EMH drop on day 0.
What does mutual fund performance indicate about market efficiency?
If managers rely on public info to pick stocks, on average their risk-adjusted returns should not outperform the market.
Why have index funds become popular?
Index funds have become popular in recent years because of an increasing belief in EMH.
What do tests and studies of Strong Form EMH investigate?
Tests of strong-form efficiency investigate insider trading and show that insider trading is abnormally profitable.
What firms are good candidates for a Seasoned Equity Offering (SEO)?
A firm whose existing projects are profitable and that has profitable investment opportunities whose capital outlays exceed available internal funds.
What firms are bad candidates for a Seasoned Equity Offering (SEO)?
A firm whose existing projects are not profitable but has profitable investment opportunities, or a firm whose existing projects are profitable but which has few profitable investment opportunities.
What are the methods of SEO offering?
- Private Placement
- Grant
- ESOP (Employee Stock Ownership Plan)
- DRIP (Dividend Reinvestment Plan)
- Rights Offering
- General Public Offering.
What are the decisions involved in a SEO?
- Choosing an underwriter
- Compensating the underwriter
- Firm Commitment or Best Efforts
- Traditional or Shelf Registration
- Mix of Primary and Secondary Shares
- Stock-Only Offering or Units.
How does the market react to a SEO announcement?
Market generally reacts negatively to a SEO announcement (-1.5% - -3%).
What is the relationship between information asymmetry and SEO?
External equity is at the bottom of the pecking order and would be offered only if the firm’s insiders have private info that the firm’s equity is overpriced.
How do market expectations affect SEO?
Market values a firm by estimating earnings and assumes that the firm’s earnings generally are sufficient to fund all investments. An SEO announcement reveals lower earnings than expected, and the market price falls.
What are agency expectations related to SEO?
- Leverage: managers may use SEO to lower leverage and decrease risk of bankruptcy.
- Overinvestment: raise money for empire building.
What is the performance trend of firms before and after SEO?
SEO firms have positive run-up 1-2 years before and underperform 1-5 years after.
What role does earnings management play in SEO?
Earnings management may explain because firms inflate earnings in advance to hype up price.
Why is payout policy irrelevant for a firm’s value in an ideal world?
Payout policies are irrelevant in an ideal world, but become relevant when considering real-world factors such as principal-agent problem, info asymmetry, and taxes/transaction costs.