Financing decisions involve the firm directly raising funds in capital markets. The first, and in many ways the most important thing for students to realize, is that capital markets generally workwell. Thus, the initial part of the chapter is on market efficiency. This chapter is essential reading for students of corporate finance. There is a distinction between a perfectly competitive market and an efficient market. Perfection implies the absence of frictions such as taxes or transaction costs. Efficiency implies only that prices fully reflect available information. It describes three levels of market efficiency and discusses empirical efficiency to show that generally markets are efficient. This chapter discusses behavioral finance which has developed to explain the anomalies and market bubbles like the one that occurred during the 1990s. Studies of “behavioral finance” show that individual investors have built-in biases and misperceptions that can veer prices away from fundamental values for prolonged periods of time. The chapter concludes with six lessons that are derived from the discussion of market efficiency.
