Вы находитесь на странице: 1из 20


There are no taxes of transaction cost in perfect capital markets, so

the total cash flows are not affected by how the firm finances them.
Therefore, the law of one pirce implies that the choice of debt of
equity financing will NOT affect the total value of the firm, its share
price, or its cost of capital.
Capital structure the relative proportions of debt, equity and
other securities that a firm had outstanding.
Rf= 5%, Rp = 10% Cost of capital = 15% (with perfect capital
Equity in a firm with no debt is called UNLEVERED EQUITY
Equity in a firm with debt is called LEVERED EQUITY
If the projects cash flows are always enough to repay the debt, the
debt is risk free.
Payments to debt holders must be made before any payments are
distributed to the equity holders.
M&M the total value of the firm does not depend on its capital
structure in perfect markets. Because CF of debt and equity sum up
to CF of the project, meaning the firm is indifferent between the two
choices of capital structure.
PV = expected cash flow (to equity) / Cost of capital. *(875)+
Leverage increases the risk of equity even when there is no risk that
the firm will default. Thus, while debt may be cheaper when
considered on its own, it raises the cost of capital for equity.
Cost of capital unlevered = 15%. Cost of debt = 5% Cost of equity =
25% combined also cost of capital of 15%, so the same as the
unlevered firm.
In capital markets leverage changes the allocation of cash flows
between debt and equity, without altering the total cash flows of the
MM set of conditions referred to as perfect capital markets:
- Investors and firms van trade the same set of securities at c
- ompetitive market prices equal to the PV of their future cash
- There are no taxes, transaction cost, or issuance cost
associated with security trading

A firms financing decision do not change the CF generated by

its investment, nor they reveal new information about them.

MM prop 1 in a perfect capital market, the total value of a firm is

equal to the market value of total CF generated by its assets and is
not affected by its choice of capital structure. Value all securities
equal the value of the assets of the firm.
When investors leverage in their own portfolio to adjust the leverage
choice made by the firm HOMEMADE LEVERAGE (perfect
substitute for the use of leverage if they can lend or borrow at the
same rates as firm)
Investor can replicate the payoffs of unlevered equity by buying
both the debt and equity of the firm. (Identical CF as the unlevered
When a firm repurchases a significant percentage of its outstanding
shares with debt, the transaction is called LEVERAGE
RECAPITILIZATION. Number of shares outstanding decrease, value
per share remains the same.
Market value balance sheets All assets and liabilities, such as
reputation, brand name etc. All values are current market values
rather than historical cost.
MM prop 1 E+D=U=A the total market value of the firms
securities is equal to the market value of its assets, whether the firm
is unlevered of levered.

E+ D

E+ D

perfect capital market

( RuRd ) (2) The effect of leverage on the return of
the levered equity. The levered equity return equals the unlevered
equity return, plus an extra kick due to leverage

MM prop 2 The cost of capital of levered equity increases with

the firms market value debt-equity ratio.
Firms wacc is independent of its capital structure and is equal to its
equity cost of capital is it is unlevered, which matches the cost of its

Enterprise value is calculated by discounting CF using the wacc.

Although debt has a lower cost of capital than equity, leverage does
not lower a firms wacc. As a result, the value of the firms free cash
flow using the wacc does not change, and so the enterprise value of
the firms does not depend on its financing choices.
Cost of debt lower shouldnt firms take as much debt? But debt
increases risk of equity. Therefore, equity holders demand a higher
risk premium and a higher expected return. The increase in cost of
equity offsets the benefit of a greater reliance on the cheaper debt
capital, so that the overall cost of capital remains the same.

E+ D
E+ D

Unlevered beta measures market risk of the firm underlying assets,

and thus can be used to assets the cost of capital for comparable
When a firm changes its capital structure, the equity beta will
change to reflect the effect of the capital structure on its risk.
e=u+ ( ud )
Debt to equity ratio (D/E) of 0.10 means that debt is 0.1 and equity
is 1
Enterprise value = - cash (negative debt). Net debt = Debt less its
holdings of excess cash or short-term investments.
Market capitalization of 114.8$, debt of 10.3$, cash and short-term
investments 33,6$ Net debt (D) = 23.3$ and EV (E+D) = 91.5$

Expected EPS increases with leverage. (not in line with MM prop 1).
But while EPS increases, volatility of share also increase due the
leverage effect shareholders will demand a higher return. Effects
cancel out and price per share is unchanged.
Dilution issuing new equity, so the CF generated by the firm must
be divided among a larger number of shares. As long as shares are
sold to investors at a fair price, there is no cost of dilution
associated with issuing equity. While the number of shares increases
when equity is issued, the firms assets also increase because of
cash raised, and the per-share value of equity remains unchanged.
Conclusion: With perfect capital markets, financial transactions
neither add nor destroy value (zero NPV), but instead represent a
repackaging of risk (and therefor return). Implying that any financial
transaction that appears to be to a good deal in terms of adding
value either is too good to be true of is exploiting some type of
market imperfection.
Any leverage increase cost of equity. Especially risk-free debt
because it doesnt share any risk
With capital markets the law of one price implies that all financial
transactions have an NPV of zero and neither create or destroy
Firms pay taxes on their profits after interest payments are reduced;
interest expenses reduce the amount of corporate tax firms must
pay. This creates an incentive to use debt.
The use of debt decreases net income (income available to equity
holders) but increases the total amount to all investors by the
interest paid on debt (interest paid to debt holders).
The gain to investors from tax deductibility of interest payments is
referred as the interest tax shield. The interest ax shield is the
additional amount that a firm would have paid in taxes id it did not
have leverage.
Interest tax shield = Corporate Tax Rate * Interest Payments.
V L =V U + PV (interest tax shield )
PV ( Interest tax shield )= C

* D (1) or

V L V U (2)

(1) if marginal tax rate is constant and no personal taxes

With tax-deductible interest, the effective after-tax borrowing rate is

r ( 1 )
rD ( 1 ) This wacc represents the effective
E+ D
E+ D
cost of capital to the firm, after including the benefits of the interest
tax shield. It is therefore lower than the pretax WACC.

The after-tax WACC declines with leverage as the interest tax shield
In case of a share repurchase by increasing leverage, share prices
would rise immediately due to the value creation of the increase in
When securities are fairly priced, the original shareholders of a firm
capture the full benefit of the interest tax shield from an increase in
Initial only E=300. Step1: announce 100 D 35 tax benefit
E=335 (share price rise) Step 2: Official debt issuance and
repurchase shares. Number of shares declines, price remains at
price of Step 1. So share price rise at the moment of the
announcement due to the present value of the (anticipated) interest
tax shield. Thus, even leverage reduces total value of equity;
shareholders capture the benefits of the interest tax shield upfront.
Individual taxes interest payments of debt are taxed as income.
Equity investors must pay taxes on dividends and capital gains.
Equity holders receive less after taxes (with personal) than debt

Even after adjusting for personal taxes, the value of a firm with
leverage exceeds the value of an unlevered firm, and there is a tax
advantage to using debt financing.
1975-2008 US most firms have raised external capital by issuing
debt. These funds have been used to retire equity and fund
No corporate tax benefit arises from incurring interest payments
that exceed EBIT. Investors will pay higher personal taxes with
excess of leverage. Optimal level of leverage from a tax saving
perspective is the level such that interest equals EBIT. Be careful
with growing firms, then its better to have Rd * D < EBIT
The optimal proportion of debt in the firms capital structure (D/E+D)
will be lower, the higher the firms growth rate.
Usually firms do not fully exploit the tax advantage of debt because
of bankruptcy cost.
Firms such as airlines whose future cash flows are unstable and
highly sensitive to shocks in the economy run the risk of bankruptcy
if they use too much leverage. The cost of bankruptcy may at least
partially offset the benefits of the interest tax shield
When a firm has trouble meeting its debt obligations the firm is in
financial distress.
After a firm defaults, debt holders are given certain rights to the
assets of the firm. In the extreme case, the debt holder takes legal
ownership of the firms assets through a process called bankruptcy.
Whether a firm defaults depends on the relative value of the firms
assets and liabilities, not on the cash flows. There are many firms
experience years of negative cash flows yet remain solvent.
Economics distress causes a significant decline in the value of
assets. In the case of success or failure. Investors have the same
outcome if firm is levered or not. In both cases they are equally
unhappy economics distress
With perfect capital markets, the risk of bankruptcy is not a
disadvantage of debt. Bankruptcy simply shifts the ownership of the
firm from equity holders to debt holders without changing the total
value available to all investors.

In the case of bankruptcy the creditors usually get the chance to

come up with a reorganization plan, else the firm is liquidated.
Lehman brothers is expected to entail bankruptcy fees of over 900$
Firms that are in financial distress can avoid filling bankruptcy by
first negotiating directly with creditors. If the reorganization succeed
it is called a workout.
Indirect cost of financial distress
- Loss of customers. Be unwilling to purchase products whose
value depends on future support or service from the firm
- Loss of suppliers. Suppliers may be unwilling to provide a firm
with inventory if they fear they will not be paid.
- Loss of employees. Difficult because cannot offer long-term
job contracts.
- Loss of receivables. Firms tend to have difficulty collecting
money that is owed to them.
- Fire sale of assets. In an effort to avoid bankruptcy companies
in distress may attempt to sell assets quickly to raise cash.
(For a lower price)
- Inefficient liquidation. Management can make negative NPV
Bankruptcy is choice the firms investors and creditors make. The
direct and indirect cost should not exceed the cost of renegotiating
with the firms creditors.
When securities are fairly priced, the original shareholder of a firm
pay the present value of the cost associated with bankruptcy and
financial distress.
The trade-off theory weighs the benefits of debt that result from
shielding cash flows from taxes against the cost of financial distress
associated with leverage.
V L =V U + PV ( tax shield )PV ( finan distress costs )
3 keyfactors determine the PV of financial distress cost
1) The probability of financial distress (50%)
2) The magnitude of the costs if the firm is in distress (20$)
3) The appropriate discount rate of the distress costs (5%)
1 Depends on the likelihood that a firm will be unable to meet its
debt commitments and therefore default. Increases with the amount
of liabilities. And volatility of cash flows and asset values
2 Real estate firms are likely to have lower costs of financial
distress, because a greater portion of their value derives from

assets that can be sold relatively easily. Technology firms higher FD

costs. Due to the potential for loss of customers, as well as the lack
of tangible assets that van be easily liquidated.
3 Depends on the firm market risk. The present value of distress
costs will be higher for high beta firms.
Agency costs are costs that arise when there are conflicts of interest
between stakeholders. Managers will generally make decisions that
increase the value of the firms equity. When a firm uses leverage, a
conflict of interest exists if investment decisions have different
consequences for the value of equity and debt. Such a conflict is
most likely to occur when the risk of financial distress is high.
For example: take actions that benefit shareholders but harm the
firms creditors and lower the total value of the firm.
Excessive risk taking in order to better serve its shareholders.
When a firm faces financial distress, shareholders can gain from
decisions that increase the risk of the firm sufficiently, even if they
have a negative NPV.
Asset substitution problem. The incentive of managers to
replace low-risk assets with riskier ones. Can lead to
Anticipating this bad behavior, security holders will pay less for the
firm initially. This cost is likely to be highest for firms that can easily
increase the risk of their investments.
Debt overhang or underinvestment problems occur when
shareholders prefer not to invest in a positive NPV project. Because
the largest part of the return goes to the debt holders. The cost is
highest for firms thar are likely to have profitable future growth
opportunities requiring large investments.
Difference in debt overhang and excessive risk-taking is that with
excessive risk-taking the NPV is negative. And with debt overhang
the NPV is positive.
Cashing out. When a firm faces financial distress shareholders
have incentive to sell equipment. Although this is negative for the
firm value, the proceeds can be used as dividends for shareholders.

When is there a sufficient debt overhang problem?


I = amount of investment

If D=0 or debt is risk free Beta = 0 then NPV > 0

Equity holders bear these agency cost. Although equity holders may
benefit at debt holders expense from these negative NPV decisions.
Debt holders recognize this possibility and pay less for the debt
when it is first issued, reducing the amount the firm can distribute to
Magnitude of agency costs likely depends on the maturity of debt.
With long-term debt, equity holders have more opportunities to
profit at the debt holders expense
Debt covenants covenants may limit the firms ability to pay
large dividends or restrict the types of investments that the firm can
take. Limit firm to pay large dividends. Are designed to prevent
management exploiting debt holders.
Debt holders benefit because management do not exploit them,
which is best for firm value. Shareholders benefit from this, because
debt holders know that they will act in best interest of the firm, so
pay more when debt is issued.
Management entrenchment facing little threat of being fired
and replaced, managers are free to run the firm in their own best
interest. As a result managers can make decisions, which benefit
themselves, but harm shareholders. Leverage Is reducing this
Advantage of using leverage is the concentration of ownership. If
manager is major shareholder, they will have strong incentives in
doing what is best for the firm, and do not overspend on luxury
(agency cost)
Empire building managers want to run larger firms, therefore the
sometimes make negative NPV investments
When cash is tight, managers are motivated to run the firm as
efficiently as possible. Leverage increases firm value, cause firm
need to pay interest, thereby reducing excess cash flows.

debt to low
Lost of tax benefits
Excessive perks
Wasteful investments
Empire building
debt to high
Excess interest payments

Financial distress cost

Excessive risk taking
Under-investment/ debt overhang

R&D intensive firms and future growth: Low current cash flows, so
need little debt for tax shield, large human capital large cost of
financial distress. Agency costs of debt are also high often
needed to raise additional capital to fund new investments. So often
maintain less than 10% leverage.
Low-growth, mature firms: Stable cash flows, few good investment
opportunities. Tax shield. Many tangible assets, assets can be
liquidated vast, so low financial distress. Often maintain greater
than 20% leverage
Management entrenchment theory: capital structure is chosen by
managers to avoid the discipline of debt and maintain their own
entrenchment. Usually under optimal debt level and increase in
response to a takeover threat or shareholders activism.
The use of leverage as a way to signal good information to investors
is known as the signaling theory of debt.
Adverse selection lees to Lemon principle: When a seller has
private information about the value of a good, buyers will discount
the price they are willing to pay due to adverse selection.
When a firm want to sell you equity, may lead you to question how
good the investment opportunity really is. Based on the lemon
principle, you therefore reduce the price you are willing to pay.
Lemon principle implies that the stock price declines on the
announcement of an equity issue; it signals to investors that its
equity may be overpriced. As a result, investors are willing to pay
less for the equity and the stock price declines.
Other view is that the stock price rises prior to the announcement,
because management wait for issuing new equity after any positive
news comes out.
Or firms tend to issue equity when information asymmetries are
minimized, such as immediately after earnings announcements.
Pecking order of financing. Managers who perceive the firms equity
is underpriced will have a preference to fund investment using
retained earnings, or debt, rather than equity.
When agencies cost are significant, short-term debt may be the
most attractive form of external financing.

16.9 BLZ 531

H 17:
Young rapidly growing firms reinvest 100% of their cash flows. But
mature, profitable firms often find they generate more cash they
need to fund all of their activities. It can hold cash reserves or pay
the cash out to shareholders via dividends or share repurchase.
Declaration date is when board authorize dividend. The firm is
then obligated to make the payment. Record date shareholders
recorded by this day receive dividend. Payable date if dividend is
Ex dividend date is the last day to buy shares to receive dividend (3
Share repurchase when firms use cash to buy its own
outstanding stock. They can be resold in the future if the company
needs to raise money.
Open market repurchase Most common way. Firm buys back
stock in the open market. May take a year and is not obligated to
repurchase the full amount.
Tender offer Shorter period (20 days). Usually a 10% - 20%
premium. Depends if shareholders tender enough shares, the firm
may cancel the offer and no buyback occurs.
Dutch auction List different prices at which it is prepared to buy
shares, shareholder in turn indicates how many shares they want to
sell for each price. Then firm buys shares for lowest price.
Targeted repurchase Firm buys back shares directly from a
major shareholder. Price is negotiated directly with the seller. When
a major shareholder desires to sell a large number of shares, but the
market is not sufficiently liquid to sustain such a large sale without
severely affecting the price. Willing to sell shares back to firm for a
With M&M does not matter if the firm goes for an share repurchase
of dividend payout.
Just before the dividend date, the stock is said to trade cumdividend because anyone who buys the stock will be entitled to the

Pcum=Current Dividend+ PV ( Future Dividend )=2+

After stock goes ex-dividend.

=2+ 40=42


In a perfect capital market, when a dividend is paid, the share price

drops with the amount of the current dividend. (2)
In perfect capital markets, an open market share repurchase had no
effect on the stock price, and the stock price is the same as the
cum-dividend price if a dividend were paid instead.
In perfect capital markets, investors are indifferent between
dividends or repurchase. By reinvesting dividends or selling shares,
they can replicate either payout method on their own (homemade
Other possibility is to issue equity to finance a larger dividend. This
option has also no effect on the share price.
A firm choice of dividend today affect the dividend it can afford to
pay in the future in an offsetting fashion. Thus, while dividends do
determine share prices, a firms choice of dividend policy does not.
With perfect capital markets, once after a firm has taken all positive
NPV investments, it is indifferent between saving excess cash and
paying it out. But with market imperfections, there is a trade-off:
Retaining cash can reduce the costs of raising capital in the future,
but it can also increase taxes and agency costs.
Corporate taxes make it costly for a firm to retain excess cash. And
cash is negative leverage, so the tax advantage of leverage implies
a tax disadvantage to holding cash. Some firms hold large cash
balances to cover potential future cash shortfalls.
Dividend smoothing is the practice of maintaining relatively
constant dividends,
Firms raise their dividends only when they perceive a long-term
sustainable increase in the expected level of future earnings( it
sends a positive signal to their investors), and cut them only as a
last resort ( bad signal about future earnings). This is called
Dividend signaling hypothesis.
Dividend payouts give the same signal as using debt. Only dividends
cuts are bad for the reputation of the manager. Not harmful as not
fulfilling debt payments.

In general, we must interpret dividends as a signal in the context of

the type of new information managers are likely to have.
Share repurchases may be less of a signal than dividends about
future earnings. Because firms do not have the obligation to fulfill
the complete repurchase. Also, it may take several years to
complete the repurchase.
It also depends if the shares are over- or undervalued in the opinion
of the managers. If they act in the best way for shareholder value,
they only will choose to repurchase if they think the shares are
undervalued. In this way, share repurchase could be a signal.
Considering taxes as the only market imperfection, when the tax
rate on dividends exceeds the tax rate on capital gains, the optimal
dividend policy is for firms to pay no dividends, firms should use
share repurchases for all payouts.
Corporate taxes make it costly for a firm to retain excess sash. Even
after adjusting for investor taxes. Retaining excess cash brings a
substantial tax disadvantage for a firm.
With a stock dividend, shareholders receive either additional
shares of stock of the firm itself (stock split) or shares of a
subsidiary (spin-off). The stock price generally falls proportionally
with the size of the split.
H 23:
Angel investors Individual investors who buy equity in small
private firms. Usually friends or relatives. Beside the funds, they can
also bring in expertise.
Venture capital firms limited partner ship that specializes in
raising money to invest in the private equity of young firms. Pension
funds are limited partners and the general partners that run the firm
are venture capitalist. They charge management fee of about
1.5%-2.5% and 20-30% of the acquired returns (carried interest).
Venture capitalist can provide substantial capital for your
companies. In return they often demand a great deal of control.
They use this control to protect their investments.
Private equity firm Organized like VC, but it invest in the equity
of existing privately held firms rather than start-up companies.
Often they purchase the outstanding equity of a publicly traded firm
(leveraged buy out).

In most cases the private equity firms uses debt as well as equity to
finance the purchase.
One difference between PE and VC is the magnitude of the
investment. Average deal size of PE in 2009 was 2$ billion.
Institutional investors (pension funds) They are major
investors in different kinds of assets, they are also active in private
Corporate investors might invest for corporate strategic
objectives in addition to the desire investment returns. (Strategic
Equity investors in private companies plan to sell their stock
eventually through one of the two main exit strategies: an
acquisition or a public offering.
Preferred stock Has a preferential dividend and seniority in any
liquidation and sometimes special voting rights. Gives the owner the
right to convert it in normal stock in the future. Angel investors
bought preferred b stocks. VC preffered c and Microsoft as corporate
investor (strategic) d stock.
Initial public offering (IPO) selling stock to the public for the
first time.
Advantages of an IPO are greater liquidity and better access to
Disadvantage is that the equity holders become more dispersed,
this lack of ownership concentration undermines investors ability to
monitor the companys management, and investors may discount
the price they are willing to pay to reflect the loss of control
Another disadvantage is the regulatory and financial reporting
Underwriter investment bank that manages the offering and
designs its structure.
The shares that are sold in the IPO may either be new shares that
raise capital (Primary offering) or existing shares that are sold as
part of their exit strategy. (Secondary offering)
Best effort IPO for smaller IPOs, the underwriter does not
guarantees that it will sell all of the stock at the offer price. Tries to
sell it for the best price. Either all the shares are sold or the deal is
called of.

Firm commitment IPO The underwrite purchases the entire

issue ( at a slightly lower price than the offer price) and then resells
it at the offer price. The risk is for the underwriter. If shares are not
sold, they have to take the loss.
Auction IPO Investors place bids over a set of periods. An auction
IPO then sets the highest price such that the number of bids at or
above that price equals the numbers of offered shares.
Especially the larger offerings are managed by a group of
underwriters, the lead underwriter is responsible for managing the
deal. Syndicate is the group of other underwriters to help and sell
the issue.
Two techniques to value a company are DCF and predict present
value of comparable. Often valued through comparable.
Once the initial price is established, the underwriters try to
determine what the market thinks of the valuation. They begin by
arranging a Road show. The underwriters travel around the world
to promote the company and explain the rational for the offer price.
Than investors give their opinion about the offer price, and the
underwriter then add up the total demand and adjust the price until
is it unlikely that the issue will fail (book building).
Underwriters appear to use the information they acquire during the
book-building stage to intentionally underprice the IPO, thereby
reducing their exposure to losses.
Greenshoe provision Option to reduce risk for underwriter.
Gives them the option to issue more stock (15%). Initially short shell
the provision. If issue is success, exercise the option. Not a success
buy shares in open market.
4 characteristics of IPOs
- On average, IPOs appear to be underpriced. The price at the
end of trading on the first day is often substantially higher
than the IPO price.
- The number of issues is highly cyclical: When times are good
the market is flooded with new issues
- The cost of IPOs are very high, and it is unclear why firms
willingly incur them. +-7% of the issue price next to the cost
of underpricing.
- The long-run performance of an IPO (3-5 years) is poor.
Underwriters underprice the IPO because of their exposure to risk.
But next to the underwriters, investors also gain from the

underpricing. Pre-IPO holders bear the cost, because they sell their
shares for less than they could get in the aftermarket.
Winners curse: Even though the average IPO may be profitable,
because you receive a higher allocation of the less successful IPOs,
your average return may be much lower.
Therefore the underwriter needs to underprice its issues on average
in order for less informed investors to be willing to participate in
Seasoned equity offering (SEO) public offers of shares after
an IPO.
Cash offer offer new shares to investors at large
Rights offer offer new shares to existing shareholders. (protect
existing shareholders from underpricing)
Researchers found that the market greets the news of an SEO with a
price decline.
H 28:
There are 2 primary mechanism by which ownership and control of a
company can change: Either another corporation or group of
individuals can acquire the target firm, or the target firm can merge
with another firm.
Mergers are correlated with market expansion and bull markets.
They called merger waves
Horizontal merger If the two companies are in the same
Vertical merger If the target industry buys or sells to the
acquirers industry.
Conglomerate merger If the two companies operate in
unrelated industries.
Two possible payments for target. Via stocks stock swap. Or via
Term sheet Summarize of the structure of the merger
transaction. Who will run the new company, the size and
composition of the new board, the location of the headquarters

Most acquires pay a acquisition premium, which is the percentage

difference between the acquisition price and the premerger price of
the target firm.
On average the target share price rise with 15% after the
announcement, were the acquires share price rise with 1%.
The acquirer pays a premium for the target, because after the
merger it could add value to the firm that an individual investor
cannot add. (synergies).
Synergies fall in two categories. Cost reduction and revenue
Cost reduction are more common because they generally translate
into layoffs of overlapping employees and elimination of redundant
Revenue enhancement is created if the merger creates possibilities
to expand into new markets or gain more costumers.
Economies of scale savings from producing goods in high
Economies of scope savings from combining the marketing and
Disadvantages are the costs associated with size. Large firm react
slowly and in a costly way. CEO is not close to the firms operations.
Vertical integration Merger of two companies in the same
industry. Enhance revenue if the company has direct control over its
inputs. Principal benefit is coordination. Oil companies are often
vertical integrated.
Expertise is a reason for a merger, to compete more efficiently.
Acquiring with a major rival enables a firms to substantially reduce
competition within the industry and thereby increase profits.
Tax savings. It might appear that a conglomerate has a tax
advantage over a single-product firm simply because the losses in
one division can be offset by profits in another division.
Diversification Is frequently used as a reason for a conglomerate
merger. Direct risk reduction, lower cost of debt, increased debt
capacity and liquidity enhancement.

It is cheaper for investors to diversify than to have the corporation

do it through a merger. (Negative effect of merger like agency cost
and inefficiently capital allocation)
Larger more diversified firms have a lower probability of bankruptcy,
therefore they can increase leverage further, enjoy greater tax
Liquidity provided by acquiring firm, to let shareholder cash out their
investment and reinvest in the diversified portfolio of acquire.
A merger can influence the EPS, even when the merger itself
creates no economic value.
So risk diversification and earnings growth are not good
justifications for a takeover intended to increase shareholder wealth.
Conflict of interest Managers may prefer to run a larger
company due to the additional payments and prestige bonus, even
if it destroys firm value. Or a CEO could be Overconfidence.
Besides the multiple valuation. Firms make a projection of the
expected cash flows that will result from the deal, and valuing those
cash flows.
Exchange ratio the number of bidder shares received in
exchange for each target share multiplied by the market price of the
acquires stock.
After the tender offer is announced, there is no guarantee that the
takeover will take place at this price. When the board thinks that the
offer is to low, they will recommend their shareholders not to tender
their shares. In the case they will, regulators might not approve the
Risk arbitrageurs Take position based on their belief about the
outcome of the deal. These positions are actually quit risky so they
do not represent true arbitrage opportunities.
Difference in tax for payout of merger. Cash would be immediate
taxed, stock change not until shareholders sells the shares.
Both boards of firms have to approve the mergers. In a friendly
takeover both boards support the merger. With a hostile
takeover the board of directors fight the takeover attempt. To
succeed, the acquirer must garner enough shares to take control
and replace the board of directors. In this case, the acquirer is called
a raider.

When premium is paid, management of target could refuse the

merger when they think the shares of acquirer are overvalued. Or if
they think the price is to low. Or in the case of replacement of the
management, they want to protect their jobs.
In the case of a hostile takeover, the acquirer will usually use a
proxy fight. The acquirer attempts to convince target shareholders
to unseat the target board by using their proxy votes to support the
acquirers candidates for election to the target board.
A Poison pill is a right that gives existing target shareholders the
right to buy shares in the target at a deeply discounted price once
certain conditions are met. This dilution can make the deal to
expensive for the acquirer, so that they have to pass on the deal.
Increases bargaining position of target firm
A way to go around the poison pill is to try replacing the whole
board, which then can vote against the poison pill.
Staggered board Every board member serves a minimum of
three years. So the acquiring company isnt able to replace the
whole board within the next shareholders meeting.
White knight if the hostile bid does not work out, the acquirer
searches for a more friendlies company to make a more lucrative
Golden parachute compensation package to the CEO if he
arrange that the target company accept the offer and that the
managers are let go.
Another defense against a takeover is a recapitalization to make the
film less attractive as target. For example issue a lot of debt and pay
this out as dividends.
The premium that the acquirer pays is approximately equal to the
value it adds, which means the target shareholders ultimately
capture the value added by the acquirer.
Shares t=0 $45. Could be $75. Firms offer $60 good deal? But
after the deal share price rise to $75. So only way to let
shareholders tender their shares is to offer $75 removes any
profit (free rider problem)
In the case of a LBO. They will buy the shares with debt and put this
debt on the balance sheet of the company. In this way it is better to
tender you shares, than keep them until the value of the company
rises. But you have to pay the shareholders the pre-merger price,
because existing shareholders anticipate the share price will be

lower once the deal is complete. . In this case all shareholders want
to tender and you have to buy all shares
Toehold When an investor has captured 10% of the shares
secretly, he has to make this public.