IMPLICATIONS OF CAPITAL-MARKETS RESEARCH FOR CORPORATE-FINANCE

We focus our discussion on two areas of capital markets-the efficient markets hypothesis and asset pricing theory. Our purpose is to examine the implications of this analysis for the practice of corporate finan ce. Thus, we focus on how an appreciation of the contributions to capi tal markets research over the past three decades can help managers mak e better business decisions. The efficient markets hypothesis holds th at a market is efficient if it is impossible to profit by trading on a vailable information. If capital markets were completely efficient, th en the market value of the firm would reflect the present value of the firm's expected future net cash flows. This has several important imp lications for corporate finance. First, managers should maximize the c urrent market value of the firm. Second, there is no benefit to manipu lating earnings per share. Third, security returns are meaningful meas ures of firm performance. Fourth, if new securities are issued at mark et prices that reflect an unbiased assessment of future payoffs, then concerns about dilution are eliminated. Finally, the extent to which f inancial markets fall short of this ideal of efficiency still places a n upper bound on such concerns. While we would not argue that ineffici encies are totally absent from financial markets or that investors alw ays react appropriately to economic events, our analysis suggests two things. First, systematically detecting or exploiting discrepancies be tween current price and true value in connection with widely recognize d information asymmetries between managers and investors is not a stra ightforward task. Second, identifying the extent to which returns exce ed a normal level of compensation for risk and other investment charac teristics (such as liquidity) is likewise difficult. Thus, a certain a mount of caution and humility would appear to be appropriate in attemp ting to exploit supposed inefficiencies. For the practice of corporate finance, asset pricing theory is most directly relevant in the capita l budgeting process. In deciding whether to undertake a project, one s hould calculate its net present value, taking the project's stream of expected net cash flows and discounting the future flows back to the p resent using the appropriate cost of capital or required rate of retur n. Asset pricing theory can play two important roles in identifying a suitable cost of capital. First asset pricing theory is helpful in cha racterizing investments that are close economic substitutes and thus s hould have similar expected rates of return. In particular, theory is indispensable in the case where no objective close substitutes for the project exist. Second, after a suitable financial substitute has been specified, one must estimate the expected return on that investment. Even if one were to assume the investment's expected return or risk pr emium is constant over time, the variability of the surprise component of returns is generally so large that the precision that can be obtai ned in estimating its expected value is quite limited. A pricing model like the CAPM reduces the problem to estimating an investment's beta coefficient along with the risk premium on the market. Theory, by itse lf, is not adequate for completely specifying the appropriate benchmar k rate of return. Hence, empirical models have an important role to pl ay in financial applications. Yet purely inductive models, divorced fr om theory, can be subject to substantial data-mining biases (these mod els may appear to perform quite well over a past period but prove unre liable in forecasting future returns). Moreover, arguments for such mo dels are predicated on a static view of financial markets, dominated b y naive investors who fail to learn from experience. This view is inco nsistent with much of the existing evidence. While research over the p ast three decades has produced dramatic additions to our knowledge of the operation of capital markets, not all the accumulated evidence fit s neatly within the profession's current intellectual framework. But t he struggle to accommodate anomalous evidence is an important aspect o f the accumulation of scientific knowledge; and this process rarely pr oceeds by completely abandoning the current-framework. Rather, it proc eeds by modifying the framework and broadening our understanding to em brace the anomalies, while retaining that which currently fits. We bel ieve this reasonably describes the process presently occurring in fina nce.