Jewish efficient market hypothesis: "All information is immediately known to Jews."

___• President Bush calls in the head of the CIA and asks "How come the Jews know everything before we do?

• The CIA chief says "The Jews have this expression 'VUS TUTZUCH' ("WHAT'S UP, MAN?" in Yiddish). They just ask each other that, and they know everything.

• The president decides to personally go undercover to determine if this is true. He gets dressed up as an orthodox Jew (black hat, beard, long pa'yes, etc), is secretly flown in an unmarked plane to New York, picked up in an unmarked car, and dropped off in Brooklyn's most Jewish neighborhood.

• Soon a little old man comes shuffling along. The president stops him and whispers "VUS TUTZUCH?"

• The old guy whispers back "Bush is in Brooklyn!"

IPO

Initial Public Offering (IPO) - First offering of stock to the general public.

Underwriter - Firm that buys an issue of securities from a company and resells it to the public.

Spread - Difference between public offer price and price paid by underwriter.

Prospectus - Formal summary that provides information on an issue of securities.

Underpricing - Issuing securities at an offering price set below the true value of the security.

Initial OfferingAverage Expenses on 1767 IPOs from 1990-1994

Value of Issues

($mil)

Direct

Costs (%)

Avg First Day

Return (%)

Total

Costs (%)

2 - 9.99 16.96 16.36

10 - 19.99 11.63 9.65

20 - 39.99 9.7 12.48

40 - 59.99 8.72 13.65

60 - 79.99 8.2 11.31

80 - 99.99 7.91 8.91

100 - 199.99 7.06 7.16

200 - 499.99 6.53 5.70

500 and up 5.72 7.53

All Issues 11.00 12.05

25 16

18 15

18 18

17 95

16 35

14 14

12 78

11 10

10 36

18 69

.

.

.

.

.

.

.

.

.

.

The Underwriters

820,1$ers UnderwritAll

61Jenrette LufkinDonaldson

71 ManhattanChase

83StearnsBear

89MorganJP

127ostonCS/First B

147 BrothersLehman

192Sachs Goldman

203Witter anStanley De Morgan

225 BrothersSaloman

$304 LynchMerrill

issues) total of ($bil

1998 in rsUnderwrite U.S. Top

Winner’s curse in IPOs

• Need to sell 1000 shares.• 500 investors are informed and 1000 are

uninformed. Each only has enough for 1 share.• Future price is 50% of the time £10 and 50% of

the time £20 (on average £15).• Informed investors know actual price. • What happens if the underwriter always charges

£15?

Winner’s curse (cont.)

• What happens if the underwriter always charges £15?

• Answer:– informed would only buy when it is £20.

– If uninformed buy it, then they get a share when it is £10 and 2/3 of the time get a share when it is £20. ---> Average return less than £15.

– Uninformed won’t buy it and issue won’t sell out!!

Winner’s curse (cont.)• At what price will the issue sell out?• Would be a p such that (1/2)[10-p]+(1/2) [(2/3)*(20-p)] =0• p= 14. The average return would be 7% over short time. • However, how much abnormal profit would uninformed

investors get? Zero!!• How much abnormal profit will the informed investors

get? 43% when they get a share which is 2/3 of the time. • Would the informed investors have any incentive to

bribe the underwriter to give them the shares?

Choices of Finance.

• Internal or External.

• External: Debt or Equity.

• Statistic of Debt/Equity ratio.

• Question: Is a high ratio bad?

Does financial planning matter?

• Practitioneers devote a lot of attention to it. Leverage. Dividend policy.

• D/E in Cement industry is 20 times D/E ratio in Pharmaceuticals. Why?

• What are the important issues?

Clientele Theory

• Also called financial marketing.• Investors with heterogeneous preferences and

needs value the same cash flow streams differently.

• Financial policy choices affect the match between the security and clientele.

• Therefore, financial policy affects the firm’s value!!

For instance, an all-equity firm may fail to exploit the demands for both riskier and safer securities.

M&M (Debt Policy Doesn’t Matter)

• Modigliani & Miller (MM 1:Debt Irrelevance)– When there are no taxes and capital markets

function well, it makes no difference whether the firm borrows or individual shareholders borrow. Therefore, the market value of a company does not depend on its capital structure.

M&M (Debt Policy Doesn’t Matter)

Assumptions• Frictionless and competitive markets.• Individuals can take same financial transactions as

the firms and at same cost.• The firms’ financing and operating decisions are

independent.• Capital structure does not affect cash flows e.g...

– No taxes– No bankruptcy costs– No effect on management incentives

M&M intuition

• Idea was revolutionary in the 50’s (won them the Nobel Prize).

• Investors’ preferences are over cash flows not securities.

• If they can make the same transactions as firms at the same prices, they will not pay a premium for firms to take such transactions.

• Put differently, if investors can reverse the firms’ financial decisions, these decisions are immaterial.

Arbitrage Proof.

• Two firms: V1=D1+E1, V2=E2.• Both generate random X from same distribution.• Firm 1 debt holders receive r * D1.• Firm 1 equity holders receive X-r*D1.• Firm 2 equity holders receive X• If V2>V1, it is profitable to sell E2 and buy V1.• If V1>V2, it is profitable to sell E1 (borrow D1)

and buy V2.

M&M thoughts

• Yogi Berra said "You better cut the pizza in four pieces because I'm not hungry enough to eat six."

• A dairy farmer cannot make more money by skimming some of the butter fat and selling it and skim milk separately even though the butter fat sells for a higher prices per kg than whole milk.

Other applications.

• Applies to Governments as well (taxes or borrowing)!

• Modigliani, F. and M. Miller "Corporate Income Taxes and the Cost of Capital" American Economic Review, June 1963, 433-443.

• Miller, M., "Debt and Taxes," Journal of Finance, June 1977, 32, 261-276.

MMII (Leverage Irrelevance)

• Interest rate on corporate debt was 5%. Stock market averages 11%. How can financing be irrelevant?

• When debt is risk free, the expected return on common stock increases linear to the D/E ratio

)( debtassetsassetsequity rrE

Drr

Proof of MMII

ed rED

Er

EDD

VXE

WACC

][

Rearranging yields

WACCED

rWACCr de )(

Taxes and Bankruptcy

• Interest is tax deductible so savings is

t* Rd * D. Present value is t*Rd*D/ Rd.– Vl is value of leveraged firm,– Vu is value of unleveraged firm– Vl=Vu+t*D – Re=Ru+(Ru-Rd)*(D/E)*(1-t)

Financial Distress

Costs of Financial Distress - Costs arising from bankruptcy or distorted business decisions before bankruptcy. (Enron has over a billion direct costs).

Market Value = Value if all Equity Financed

+ PV Tax Shield

- PV Costs of Financial Distress

Financial Distress

Debt

Mar

ket V

alue

of

The

Fir

m

Value ofunlevered

firm

PV of interesttax shields

Costs offinancial distress

Value of levered firm

Optimal amount of debt

Maximum value of firm

Is this really true (Miller 1977)?

• Bankruptcy costs are not that high.

• If income tax rate is progressive: higher income, more taxes.

• Then general equilibrium effects will cause rates such that the corporate tax shield is equal to the personal income tax.

• This means that the MM results return!!

Pecking Order Hypothesis

• Managers know more than outside investors.• This explains why a new issue lowers the price

(they wouldn’t do it if they felt the stock was undervalued).

• Firms prefer internal financing in order not to send adverse signals that may lower the stock price.

• If external financing is required, they issue debt first and then equity in order to avoid this bad signal.

Trade-off Theory

• The optimal D/E structure depends upon the trade-off between interest tax shields and what financial troubles are out there.

• Companies with safe, tangible assets ought to have high D/Es.

• Companies with risky, intangible assets ought to rely on equity.

• Highly profitable firms sometimes don’t take on debt, like MSFT, JNJ but GE has 4.25

Financial Slack

• Financial Slack is valuable in order to let bond holders feel that the bonds are risk free.

• Financial Slack may have a cost in that financial distress gives strong incentives for managers (especially entrenched ones) to work their butts off.

Moral hazard.

• What happens if all assets are not in place?• Switching to a riskier project is

advantageous to share-holders.• Why? On plus side, bond holders don’t

gain, but loose more on the minus side since chance of default goes up.

• May invest in Negative NPV projects!!• Does convertible bonds help alleviate this?

JB

• JB Manufacturing is an all equity firm. The equity is worth £2 million. The cost of equity is 18%. JB pays no taxes. JB plans on issuing £400,000 in debt and use the proceeds to repurchase equity. The cost of debt is 10%.

• What will the cost of capital be after repurchase?• What will the cost of equity be?