Corporate-Financing Decisions and Efficient Capital Markets

The section on value concentrated on the firm’s capital budgeting decisions—theleft-hand side of the balance sheet of the firm. This chapter begins our analysis ofcorporate-financing decisions—the right-hand side of the balance sheet. We takethe firm’s capital budgeting decision as fixed in this section of the text.

The point of this chapter is to introduce the concept of efficient capital markets and itsimplications for corporate finance. Efficient capital markets are those in which current mar-ket prices reflect available information. This means that current market prices reflect theunderlying present value of securities, and there is no way to make unusual or excess prof-its by using the available information.

This concept has profound implications for financial managers, because market effi-ciency eliminates many value-enhancing strategies of firms. In particular, we show that inan efficient market

1. Financial managers cannot time issues of bonds and stocks.
2. The issuance of additional stock should not depress the stock’s market price.
3. Stock and bond prices should not be affected by a firm’s choice of accounting method.

Ultimately, whether or not capital markets are efficient is an empirical question. We will de-scribe several of the important studies that have been carried out to examine efficient markets.


Earlier parts of the book show how to evaluate projects according to the net present valuecriterion. The real world is a competitive one where projects with positive net present valueare not always easy to come by. However, through hard work or through good fortune, afirm can identify winning projects. For example, to create value from capital budgeting de-cisions, the firm is likely to

1. Locate an unsatisfied demand for a particular product or service.
2. Create a barrier to make it more difficult for other firms to compete.
3. Produce products or services at lower cost than the competition.
4. Be the first to develop a new product.

The next five chapters concern financing decisions. Typical financing decisions includehow much debt and equity to sell, what types of debt and equity to sell, and when to selldebt and equity. Just as the net present value criterion was used to evaluate capital budget-ing projects, we now want to use the same criterion to evaluate financing decisions.
Though the procedure for evaluating financing decisions is identical to the procedurefor evaluating projects, the results are different. It turns out that the typical firm has manymore capital-expenditure opportunities with positive net present values than financing opportunities with positive net present values. In fact, we later show that some plausiblefinancial models imply that no valuable financial opportunities exist at all.

Though this dearth of profitable financing opportunities will be examined in detaillater, a few remarks are in order now. We maintain that there are basically three ways to cre-ate valuable financing opportunities:

1. Fool Investors. Assume that a firm can raise capital either by issuing stock or by is-suing a more complex security, say, a combination of stock and warrants. Suppose that, intruth, 100 shares of stock are worth the same as 50 units of our complex security. If investorshave a misguided, overly optimistic view of the complex security, perhaps the 50 units canbe sold for more than the 100 shares of stock can be. Clearly this complex security providesa valuable financing opportunity because the firm is getting more than fair value for it.

Financial managers try to package securities to receive the greatest value. A cynic mightview this as attempting to fool investors. However, empirical evidence suggests that investorscannot easily be fooled. Thus, one must be skeptical that value can easily be created here.

The theory of efficient capital markets expresses this idea. In its extreme form, it saysthat all securities are appropriately priced at all times, implying that the market as a wholeis very shrewd indeed. Thus, corporate managers should not attempt to create value by fool-ing investors. Instead, managers must create value in other ways.

2. Reduce Costs or Increase Subsidies.We show later in the book that certain forms offinancing have greater tax advantages than other forms. Clearly, a firm packaging securitiesto minimize taxes can increase firm value. In addition, any financing technique involvesother costs. For example, investment bankers, lawyers, and accountants must be paid. A firmpackaging securities to minimize these costs can also increase its value. Finally, any financ-ing vehicle that provides subsidies is valuable. This last possibility is illustrated below.

Suppose Vermont Electronics Company is thinking about relocating its plant toMexico where labor costs are lower. In the hope that it can stay in Vermont, thecompany has submitted an application to the State of Vermont to issue $2 millionin five-year, tax-exempt industrial bonds. The coupon rate on industrial revenuebonds in Vermont is currently 5 percent. This is an attractive rate because the nor-mal cost of debt capital for Vermont Electronics Company is 10 percent. What isthe NPV of this potential financing transaction?

This transaction has a positive NPV. The Vermont Electronics Company obtainssubsidized financing where the amount of the subsidy is $379,079.

3. Create a New Security. There has been a surge in financial innovation in recent years.For example, in a speech on financial innovation, Nobel laureate Merton Miller asked therhetorical question, “Can any twenty-year period in recorded history have witnessed evena tenth as much new development? Where corporations once issued only straight debt andstraight common stock, they now issue zero-coupon bonds, adjustable-rate notes, floating-rate notes, putable bonds, credit-enhanced debt securities, receivable-backed securities,adjusted-rate preferred stock, convertible adjustable preferred stock, auction-rate pre-ferred stock, single-point adjustable-rate stock, convertible exchangeable preferredstock, adjustable-rate convertible debt, zero-coupon convertible debt, debt with manda-tory common-stock-purchase contracts—to name just a few!”1And, financial innovationhas occurred even more rapidly in the years following Miller’s speech.

Though the advantage of each instrument is different, one general theme is that thesenew securities cannot easily be duplicated by combinations of existing securities. Thus, apreviously unsatisfied clientele may pay extra for a specialized security catering to itsneeds. For example, putable bonds let the purchaser sell the bond at a fixed price back tothe firm. This innovation creates a price floor, allowing the investor to reduce his or herdownside risk. Perhaps risk-averse investors or investors with little knowledge of the bondmarket would find this feature particularly attractive.

Corporations gain from developing unique securities by issuing these securities at highprices. However, we believe that the value captured by the innovator is small in the long runbecause the innovator usually cannot patent or copyright his idea. Soon many firms are is-suing securities of the same kind, forcing prices down as a result.2

This brief introduction sets the stage for the next five chapters of the book. The rest ofthis chapter examines the efficient-capital-markets hypothesis. We show that if capital mar-kets are efficient, corporate managers cannot create value by fooling investors. This is quiteimportant, because managers must create value in other, perhaps more difficult, ways. Thefollowing four chapters concern the costs and subsidies of various forms of financing. Adiscussion of new financing instruments is postponed until later chapters of the text.

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