BMA 12e PPT Ch13 16 PDF

CHAPTER
13 13-1
EFFICIENT MARKETS
AND BEHAVIORAL FINANCE
Brealey, Myers, and Allen

Principles of Corporate Finance
12th Edition
Slides by Matthew Will
Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Learning Objectives
13-2
• Efficient Markets?
o What is an Efficient Market
o The Evidence Against Market Efficiency
o The Five Lessons of Market Efficiency
• Payout Policy
o Information in Dividends and Stock Repurchases
o Dividends or Repurchases?
o Payout Policy and the Life Cycle of the Firm
Return to NPV
13-3
• Although it is helpful to separate investment

and financing decisions, there are basic
similarities in the criteria for making them
• NPV employs discount rates

• These discount rates are risk adjusted
• The risk adjustment is a byproduct of market
established prices
Return to NPV: Example
13-4
• As part of its policy of encouraging small

business, The government is lending you
$100,000 for 10 years at 3% and only requiring
interest payments prior to maturity. Since 3%
is obviously below market, what is the value of
the below market rate loan?
• Assume the market return on equivalent risk
projects is 10%.
Return to NPV: Example
13-5
NPV  amount borrowed - PV of interest pmts

- PV of loan repayment
 10 3,000  100,000
NPV  100,000   t 
 10
 t 1 (1.10)  (1.10)
 100,000  56,988
 $43,012
Random Walk Theory
13-6
• Kendall’s discovery n 1953: The movements of

stock prices from day to day DO NOT reflect
any pattern
• Statistically speaking, the movement of stock
prices is random
Random Walk Theory: Coin Toss Game
13-7
• You are given $100 to play a game. At the end

of each week a coin is tossed. If it comes up
heads, you win 3% of your investment; if it is
tails, you lose 2.5%
• What are the possible outcomes at the end of

the second week?
Random Walk Theory: Coin Toss Game
13-8
Heads
$106.09
Heads
$103.00
$100.43
Tails
$100.00
Heads
$100.43
$97.50
Tails
$95.06
Tails
Random Walk Theory
13-9
• The process is a random walk because

successive changes in value are independent.
o That is, the odds each week are the same,
regardless of the value at the start of the week or of
the pattern of heads and tails in the previous weeks
• When Kendall suggested that stock prices

follow a random walk, he was implying that the
price changes are independent of one another
Random Walk Theory
13-10
Random Walk Theory
13-11
Random Walk Theory
13-12
Random Walk Theory
13-13
Efficient Market Theory
13-14
• Suppose on the contrary that today’s price

change give investors information about the
likely change tomorrow; in other words, that
changes in stock price were expected to
persist for several months
13-15
$80
Actual price as soon as upswing
Microsoft stock price, $
is recognized
60
Upswing
40
Cycles
disappear
once
identified Last This Next
month month month
13-16
• What will happen when investors recognize the

cycle? It will self-destruct:
o Investors will rush to buy and they will stop buying
only when the stock offers a normal risk-adjusted
rate of return
• We see now why prices in competitive markets

must follow a random walk
13-17
• If past price changes could be used to predict

future price changes, investors could make
easy profits. But in competitive markets, there
are no such free lunches
o As investors try to take advantage of any
information in past prices, prices adjust immediately
until the superior profits from studying price
movements disappear
• All the information in past prices will be

reflected in today’s stock price, not tomorrow’s
13-18
• Weak Form Efficiency

o Market prices reflect all historical information
• Semi-Strong Form Efficiency

o Market prices reflect all publicly available
information
• Strong Form Efficiency

o Market prices reflect all information, both public and
private
13-19
• To test for semi-strong efficiency, researchers

have measured how rapidly security prices
respond to different items of news, such as
earnings or dividend announcements, news of
a takeover, etc)
• Suppose that you need to understand how

stock prices of takeover targets respond when
the takeovers are first announced
13-20
• With daily returns on a large sample of targets,

you could calculate the average return on
target-company stocks in the days before the
announcement and immediately after it:
𝐴𝑏𝑛𝑜𝑟𝑚𝑎𝑙 𝑠𝑡𝑜𝑐𝑘 𝑟𝑒𝑡

= 𝑎𝑐𝑡𝑢𝑎𝑙 𝑠𝑡𝑜𝑐𝑘 𝑟𝑒𝑡𝑢𝑟𝑛 − 𝐸𝑥𝑝 𝑠𝑡𝑜𝑐𝑘 𝑟𝑒𝑡𝑢𝑟𝑛
𝐴𝑏𝑛𝑜𝑟𝑚𝑎𝑙 𝑠𝑡𝑜𝑐𝑘 𝑟𝑒𝑡𝑢𝑟𝑛 = 𝑟෤ − (𝛼 + 𝛽𝑟෤𝑚 )

• This abnormal return should reflect firm -
specific news only
13-21
Sample of 17000 firms
13-22
Average Annual Return on Mutual Funds and the

Market Index
Price Anomalies
13-23
Log Deviations From Royal Dutch Shell/Shell T&T Parity, 1980 - 2004
Behavioral Finance
13-24
• Why prices depart from fundamentals?

Some believe it is due to behavioral psychology:
People are not 100% rational 100% of the time
oAttitudes towards risk
oBeliefs about probabilities
oSentiment
oLimits to arbitrage
oIncentive problems and the subprime crisis
Behavioral Finance
13-25
Spread between Bullish and Bearish Investors
Lessons of Market Efficiency
13-26
• Markets have no memory

• Trust market prices
• Read the entrails
• The do it yourself alternative
• Seen one stock, seen them all
CHAPTER
16 16-27
PAYOUT POLICY
Brealey, Myers, and Allen

Principles of Corporate Finance
12th Edition
Slides by Matthew Will
Payout Policies
13-28
• Cash Dividend vs. Stock Repurchase
US firms from 2003-2013
Dividend & Stock Repurchases
13-29
U.S. Data 1980-2013
How Firms Pay Dividends
13-30
Stock Dividend - Distribution of additional

shares to a firm’s stockholders
Stock Splits - Issue of additional shares to

firm’s stockholders
Cash Dividend - Payment of cash by the firm

to its shareholders
-Regular
-Special
How Firms Pay Dividends
13-31
• Example of stock dividends: if the firm pays a

stock dividend of 5%, it sends each
shareholder 5 extra shares for every 100
shares currently owned
• A stock dividend is similar to a stock split. Both

increase the number of shares but do not affect
the company’s assets, profits, or total value. So
both reduce value per share
How Firms Repurchase Stock
13-32
• Stock Repurchase - Firm buys back stock

from its shareholders
• Stock Repurchase (4 methods)

1. Buy shares in the open market
2. Tender offer to shareholders
o Firms offer to buy back a stated number of shares
at a fixed price (typically +20% wrt current market
level)
How Firms Repurchase Stock
13-33
3. Dutch auction:
o The firm states a series of prices at which it is
prepared to repurchase stock.
o Shareholders submit offers declaring how many
shares they wish to sell at each price
o The company calculates the lowest price at which it
can buy the desired number of shares
4. Private negotiation with a major shareholder
Dividend Terms
13-34
• Declaration Date
• Ex-Dividend Date
• Record Date
• Payment Date
Dividend Payments
13-35
Dec.15, 2014 Feb. 4, 2015 Feb. 6, 2015 Mar. 3, 2015
Pfizer Dividend will be

Shares start to Dividend checks
declares regular paid
trade ex are mailed
quarterly dividend to shareholders
dividend. to shareholders.
of $.28 per share. registered
on this date.
Declaration Ex-dividend Record Payment

date date date date
The Information Content of Dividends
13-36
• Senior Executive Dividend Policy Features

(How Dividends are Determined)
1. Managers are reluctant to make dividend

changes that might have to be reversed
2. Managers “smooth” dividends and hate to cut
them. Dividends changes follow shifts in
long-run, sustainable levels of earnings
3. Managers focus more on dividend changes
than on absolute levels
Survey on the Payout Decision
13-37
Dividend Decision Survey (2004)
13-38
• Announcement of a dividend increase is good

news to investors:
o Investors know that managers are reluctant to reduce
dividends and will not increase dividends unless they
are confident that the payment can be maintained
• Announcement of a higher dividend signals

managers’ confidence in future profits
• Information content of dividends implies that

dividend increases predict future profitability.
13-39
• When an increase in dividends is announced,

analysts generally up their forecast of the current
year’s earnings
• Investors care about the change, it is viewed as an

indicator of the sustainability of earnings
• How preoccupied investors are with dividend

changes also depends on the countries
• Not all dividend cuts are bad news
Information Content of Share Repurchases
13-40
• It is not a commitment to continue repurchases in

later years. So the information content of is less
strongly positive than dividend announcement
• Investors may applaud repurchases if they worry

that managers would otherwise fritter away the
money on perks or unprofitable empire building
• Stock repurchases may also be used to signal a

manager’s confidence in the future and that their
stocks are undervalued
The Information Content: Wrap up
13-41
• Dividends and stock repurchase decisions

contain information. But the information content
in the decisions varies
• Dividend increases could signal increased
future profits
• Stock repurchases may signal managers’
confidence in the future and that their stocks
are undervalued
• The signal varies based on prior information
about the company
Dividends or Repurchases? The Payout
Controversy
13-42
• Announcements of dividends and repurchases

can convey information about management’s
confidence and so affect the stock price.
• But eventually the stock price change would

happen anyway as information seeps out
through other channels. Does payout policy
affect value in the long run?
Dividends or Repurchases? The Payout
Controversy
13-43
1. On the right, conservatives argue that

investors pay more for firms with generous,
stable dividends
2. On the left, repurchases are better because
they mean higher stock prices and capital
gains have been taxed at lower effective
rates than dividends
3. In the center, the choice between dividends
and repurchases has no effect on value
Dividend Policy is Irrelevant
13-44
Miller and Modigliani

• Since investors do not need dividends to
convert shares to cash, they will not pay higher
prices for firms with higher dividend payouts:
o Dividend policy will have no impact on the value
of the firm
• Dividend policy is value-irrelevant in a world

without taxes, transaction costs, and other
market imperfections. Also, investment and
debt-financing policy are fixed
Dividend Policy is Irrelevant: Example
13-45
• A simple example to show MM’s irrelevance

result
• We show that value is also unaffected if the

company increases the dividend and finances
the increase with an issue of shares
13-46
• Rational Demiconductor has one million shares

outstanding and the following market-value
balance sheet:
• Assume it has no debt. All of its fixed assets

are paid for
13-47
• Working capital includes enough cash to

support operations, so the $1m cash is surplus
• Its market capitalization is $11 million, so each
share is worth $11
• If it now pays out the surplus cash, market
capitalization must fall to $10 million:
13-48
• But the price per share depends on whether

the surplus cash is paid out as a dividend or by
repurchases:
• If a dividend of $1 per share is paid,

o 1 million shares are still outstanding and stock price
is $10
o Shareholders’ wealth, including the cash dividends,
is $10 + 1 = $11 per share
13-49
• If Rational repurchases shares instead:

o It spends $1 million to repurchase 90,909 shares at $11
each, leaving 909,091 shares outstanding. Stock price
remains at $11 ($10 million divided by 909,091 shares)
o Shareholders’ wealth is $11 per share.
• Thus shareholder wealth is the same with

dividends as with repurchases:
o If Rational pays a cash dividend, wealth is $10 + 1 =
$11, including the dividend.
o If Rational repurchases, there is no dividend but each
share is worth $11.
Dividend Policy is Irrelevant: Wrap up
13-50
• A repurchase does not increase the stock price,

but it avoids the fall in stock price that would occur
on the ex-dividend day if the amount spent on
repurchases were paid out as cash dividends
• Repurchases do not guarantee a higher stock

price, but only a stock price higher than if a
dividend were paid instead. Repurchases also
reduce the number of shares outstanding, so
future earnings per share are higher than if the
same amount were paid out as dividends
Dividend Policy is Irrelevant: Wrap up
13-51
• If MM is correct, then the choice between

dividends and repurchases is merely tactical:
o A company will decide to repurchase to retain the
flexibility to cut back payout if valuable investment
opportunities arise
Stock Repurchases and DCF Models of
Share Price
13-52
• To Calculate Market Capitalization (the

aggregate value of all shares)
o Forecasting and discount FCF paid to shareholders
o To calculate share price, divide market
capitalization by number of outstanding shares
• Calculate Present Value of Dividends Per
Share
o Accounting for increased dividend growth rate per
share, caused by declining number of shares as
shares are repurchased
Dividends and Share Issues
13-53
• So far, dividend policy is the choice between

cash dividends or repurchases:
o If we hold total payout constant, smaller dividends
mean larger repurchases
• But MM derived their dividend-irrelevance
theorem when repurchases were rare
• MM asked whether a corporation could
increase value by paying larger cash
dividends. But they insisted on holding
investment and debt-financing policy fixed
Dividends and Share Issues
13-54
• Suppose Rational Demiconductor has paid out any

surplus cash. Now it wants to try to impress
investors by paying out an even larger dividend
• If the firm fixes its borrowing, the only way it can

finance the extra dividend is to print more shares
• How can the firm sell more shares when its assets,
earnings, investment opportunities, and, therefore,
market value are all unchanged?
o Transfer of value from the old to the new stockholders
Dividend Policy
13-55
Before After
Dividend Dividend
New
stockholders
Total value of firm
Each share
worth this
before … … and
worth
this
after Old
stockholders
Total Total
number of number of
shares shares
Example of 1/3rd of worth paid as dividend and raising money via new shares
Dividend Policy
13-56
• Two ways of raising cash for the firm’s original

shareholders
Dividend financed No dividend, no
by stock issue stock issue
New stockholders New stockholders
Shares
Cash
Firm Cash Shares
Cash
Old stockholders Old stockholders
Dividends Increase Value
13-57
• Market Imperfections and Clientele Effect

• MM assumed absolutely perfect and efficient
capital markets. The right-wing payout party
points to real-world imperfections that could
make high dividend payout ratios better than
low ones:
o Example: Some financial institutions are legally
restricted from holding stocks lacking established
dividend records
13-58
• Market Imperfections and Clientele Effect

• There are natural clients for high-payout stocks: Those
who look to their stock portfolios for a steady source of
cash. In principle, they could just sell off a small
fraction. Still, they might prefer steady dividends
(behavioral psychology, transaction costs, self-
discipline)
• It does not follow that any particular firm can benefit by
increasing its dividends. The high dividend clientele
already have plenty of high dividend stock to choose
13-59
• Dividends as Signals
• Dividend increases send good news about
cash flows and earnings. Dividend cuts send
bad news
• Because a high dividend payout policy will be

costly to firms that do not have the cash flow to
support it, dividend increases signal a
company’s good fortune and its manager’s
confidence in future cash flows
13-60
• Investment Policy, and Management Incentives

• Paying out funds to shareholders prevents managers
from misusing or wasting funds
• The willingness of mature corporations to make

generous payouts shows that corporate governance
works in developed economies. But governance is less
effective in many EM and managers’ and stockholders’
interests are not always aligned
o Dividend payout ratios are smaller where governance is weak
Dividends Decrease Value
13-61
• Tax Consequences
• If dividends are taxed more heavily than capital
gains, taxpaying investors should welcome such a
move and value the firm more favorably.
Companies can convert dividends into capital
gains by shifting their dividend policies
• In such a tax environment, the total cash flow
retained by the firm and/or held by shareholders
will be higher than if dividends are paid
Taxes and the Radical Left
13-62
• Since capital gains are taxed at a lower rate

than dividend income, companies should pay
the lowest dividend possible
• Dividend policy should adjust to changes in the
tax code
Empirical Evidence on Dividends & Taxes
13-63
• In recent years, the case for low dividends has

been weakened
o Top tax rates on dividends: 15%
o Top tax rates on capital gains: 15%
• One advantage to investors:
o Capital gains taxes are deferrable
• One advantage to corporations:
o Corporations pay corporate income tax on only
30% of any dividends received from investments in
other corporations
1. Payout Policy and the Life Cycle of Firms
13-64
• Young growth firms have plenty of profitable

investment opportunities: It is efficient to retain
and reinvest all operating CF. Also, it avoids
costs of issuing securities and minimizes
shareholders’ taxes
• Investors are not worried about wasteful
overinvestment, because investment
opportunities are good, and managers’
compensation is tied to stock price
13-65
• As the firm matures, positive-NPV projects

become scarcer relative to cash flow: Firm
begins to accumulate cash & investors begin to
worry about overinvestment or excessive perks
• The payout may come as share repurchases,

but initiating a regular cash dividend sends a
stronger signal of financial discipline:
o Commitment to financial discipline can outweigh the
tax costs of dividends.
13-66
• As the firm ages, more and more payout is

called for. The payout may come as higher
dividends or larger repurchases. Sometimes
the payout comes as the result of a takeover
Payout Policy and the Life Cycle of Firms
13-67
• Questions for the Financial Manager

1. Is the company generating FCF>0 after
making all investments with NPVs>0 and is
the positive free cash flow likely to continue?
2. Is the firm’s debt ratio prudent?
3. Are the company’s holdings of cash a
sufficient cushion for unexpected setbacks
and a sufficient war chest for unexpected
opportunities?
13-68
• Apple stock price increased, despite paying no

dividend. It sent a signal of growth

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CHAPTER

Brealey, Myers, and Allen

• Although it is helpful to separate investment

• NPV employs discount rates

• As part of its policy of encouraging small

NPV  amount borrowed - PV of interest pmts

• Kendall’s discovery n 1953: The movements of

• You are given $100 to play a game. At the end

• What are the possible outcomes at the end of

• The process is a random walk because

• When Kendall suggested that stock prices

• Suppose on the contrary that today’s price

• What will happen when investors recognize the

• We see now why prices in competitive markets

• If past price changes could be used to predict

• All the information in past prices will be

• Weak Form Efficiency

• Semi-Strong Form Efficiency

• Strong Form Efficiency

• To test for semi-strong efficiency, researchers

• Suppose that you need to understand how

• With daily returns on a large sample of targets,

𝐴𝑏𝑛𝑜𝑟𝑚𝑎𝑙 𝑠𝑡𝑜𝑐𝑘 𝑟𝑒𝑡

𝐴𝑏𝑛𝑜𝑟𝑚𝑎𝑙 𝑠𝑡𝑜𝑐𝑘 𝑟𝑒𝑡𝑢𝑟𝑛 = 𝑟෤ − (𝛼 + 𝛽𝑟෤𝑚 )

Sample of 17000 firms

Average Annual Return on Mutual Funds and the

• Why prices depart from fundamentals?

Spread between Bullish and Bearish Investors

• Markets have no memory

Brealey, Myers, and Allen

• Cash Dividend vs. Stock Repurchase

US firms from 2003-2013

U.S. Data 1980-2013

Stock Dividend - Distribution of additional

Stock Splits - Issue of additional shares to

Cash Dividend - Payment of cash by the firm

• Example of stock dividends: if the firm pays a

• A stock dividend is similar to a stock split. Both

• Stock Repurchase - Firm buys back stock

• Stock Repurchase (4 methods)

4. Private negotiation with a major shareholder

Dec.15, 2014 Feb. 4, 2015 Feb. 6, 2015 Mar. 3, 2015

Pfizer Dividend will be

Declaration Ex-dividend Record Payment

• Senior Executive Dividend Policy Features

1. Managers are reluctant to make dividend

Dividend Decision Survey (2004)

• Announcement of a dividend increase is good

• Announcement of a higher dividend signals

• Information content of dividends implies that

• When an increase in dividends is announced,

• Investors care about the change, it is viewed as an

• How preoccupied investors are with dividend

• Not all dividend cuts are bad news

• It is not a commitment to continue repurchases in

• Investors may applaud repurchases if they worry

• Stock repurchases may also be used to signal a

• Dividends and stock repurchase decisions

• Announcements of dividends and repurchases

• But eventually the stock price change would

1. On the right, conservatives argue that

Miller and Modigliani

• Dividend policy is value-irrelevant in a world