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Financial Management
2nd edition
Corporate Finance
7th edition
Chapters 9, 10, 29
Chapter 3 Equity Financing
debt holder claims must be paid in full before equity holder claims can be paid
equity holders elect the board of directors and thus control the firm
interest payments are tax-deductible while corporate tax is paid on dividends
There are three different types of equity: (1) common stock, (2) preferred stock, and (3) warrants.
1. Common Stock
Common stock: share of ownership in a corporation that usually entitles its holders to vote on the
corporation’s affairs. Dual-class common stock: two classes of common (class A and class B) which
differ in terms of their voting rights.
2. Preferred Stock
Preferred stock: share that gives its holders a claim on a firm’s earnings that must be paid before
dividends on its common stock can be paid. Cumulative preferred stock: if the corporation stops
paying dividends, unpaid dividends accumulate and must be paid in full before dividends can be paid
to common shareholders. Convertible preferred stock: preferred shares which can be converted into
a certain number of common shares. Adjustable-rate preferred stock: preferred stock with the
dividend adjusted quarterly to changes in the short-term interest rate. Monthly income preferred
securities (MIPS): a combination of equity (like accumulative preferred stock on balance and in
dividends) and debt (fixed payment and tax-deductible interest).
3. Warrants
Warrant: long-term call options on the issuing firm’s stock. Call option: holder’s right to buy a firm’s
share at a prespecified price in a given period. Warrants are often part of a unit offering (two or more
securities offered as a package).
U.S. equity is owned by two groups: individuals and institutions (1950: 6%; 1999: 50%).
Raising equity on foreign markets requires companies to fulfill foreign regulations. Non-U.S.
companies can avoid this by using American Depository Receipts (ADRs): depositing shares on a
money-center bank in New York, which issues ADRs (securities with a claim on deposited shares’
cash flows).
Exchanges
There are numerous exchanges, all have their own listing requirements. A listed company gets a
specialist which makes a market in the security (both as broker and as dealer). Specialists take both
market orders (order to buy or sell at any market price) and limit orders (order to buy or sell at a
prespecified price).
Unlisted stocks are traded over the counter or through a network of dealers, like Nasdaq. On
Nasdaq, stock has about ten market makers providing a bid-ask quote and a depth (number of
shares).
Electronic Communication Networks (ECNs)
ECNs have become increasingly popular because they are always open.
Efficient market hypothesis: market in which prices ‘fully reflect’ available information.
Result 3.1 The stock market plays an important role in allocating capital. Sectors of the economy
that experience favorable stock returns can more easily raise new capital for investment. Given this,
the stock market is likely to more efficiently allocate capital if market prices accurately reflect the
investment opportunities within an industry.
Private equity: equity that is not registered with the SEC and cannot be traded in the public equity
markets. This is often provided by large institutions specialized in venture capital (providing equity
capital for emerging companies) or inrestructuring (providing equity capital to make fundament
changes).
The U.S. has a large and active initial public offering (IPO) market for common stock.
Hot issue periods: periods during which large numbers of firms are going public.
Result 13.2 IPOs are observed frequently in some years and not in other years. The available
evidence suggests that the hot issue periods are characterized by a large supply of available capital.
Therefore, firms are better off going public during a hot issue period.
Going public is expensive: about 25% of the money raised. When public, the firm faces costs of
fulfilling regulation, and is sometimes forced by external parties to change its strategy.
expensive
costs of dealing with shareholders
information is revealed to competitors
public pressure
In general, a firm should go public when the benefits of doing so exceed the costs.
The registration statement: statement disclosing all material information about the firm
(information that, if omitted, would significantly alter the values of the firm)
Marketing the issue: management and underwriter explain and try to sell the IPO to institutional
investors.
Pricing the issue: after SEC approval, the price, number of shares and distribution has to be
determined. Oversubscribed offering: when investors want to buy more shares than available.
Book building or fixed-price method. Book-building process: investors have to subscribe for an
IPO before the share price is determined. Fixed-price method: the offering price is made public
before applying for an IPO. In this case, shares are allocated pro rata in oversubscribed IPOs.
3.8 Stock Returns Associated with IPOs of Common Equity
Like everywhere, IPOs in the U.S. are generally underpriced (in the late 1990s by about 17%).
While firms want to raise as much capital as possible, underwriters will underprice IPOs to sell all
their shares easily and to avoid costly lawsuits because of subsequently underperforming firms.
The Case Where the Managers of the Issuing Firm Have Better Information Than Investors
It is hypothesized that entrepreneurs who expect their firms to do well have the largest incentive to
underprice their shares, because this will attract investors in the next, seasoned offering.
The Case Where Some Investors Have Better Information Than Other Investors
While informed investors only invest in the underpriced stars, uninformed investors also invest in
overpriced dogs. This is the winner’s curse: the winner of an auction is the one paying too much.
Therefore, uninformed investors are only willing to invest if all shares are somewhat underpriced
(Rock’s model).
The Case Where Investors Have Information That the Underwriter Does Not Have
The Rock model explains underpricing in fixed-price methods. The book-building procedure provides
an incentive for investors to underbid. Small investors might also follow the market leader. Therefore,
during the pricing and allocation, investment banks underreact to information provided by investors
and allocate more shares to investors providing more favorable information. According to Hanley,
the demand by investors (strong, as expected, or low) determined the relation between the offering
price and the expected price range (above, within, below).
Valuing risky investments is more difficult than riskless investments because it is more complex to
determine forecasted cash flows and the appropriate discount rate. Two ways to forecast: (1)
forecast expected cash flows, and (2) forecast cash flows adjusted for risk. Risk-adjusted discount
rate method (to obtain PV):
Estimate expected future cash flows of asset. Expected cash flow: probability-weighted sum of
cash flow in each of a variety of scenarios.
Obtain risk-adjusted discount rate and discount cash flows.
Comparison is difficult, because the assets are rarely traded. However, claims on the cash flows
generated by the assets are publicly available. By determining the betas of the claims, there are two
ways to determine the risk-adjusted discount rate:
1. - unlevering the beta: convert equity and debt betas to asset beta
- convert asset beta to asset expected return (= discount rate) using an asset pricing
model
2. - convert equity beta to equity expected return using an asset pricing model
- unlevering the equity return: convert expected return on equity to expected return on
assets (= discount rate)
Managers are often unaware of what they are forecasting or how they are adjusting for risk.
determine certainty equivalents: hypothetical riskless cash flow (conservatively forecasted cash
flows)
discount certainty equivalents at risk-free rate
The choice between risk-adjusted discount rates or the certainty equivalent method depends on the
information available. Both methods should lead to the same present value, because both apply the
general valuation principle: identify a tracking portfolio and use its value as an estimate for future
cash flows.
The tracking portfolio approach: market price of financial investments tracking the project’s future
cash flows has the same value as the project’s future cash flows. Usually, there’s a tracking error.
Perfect tracking (when tracking portfolio and CAPM/APT methods provide same outcome) is very
unlikely. Therefore, the tracking portfolio should have the same expected value, not contain
unsystematic risk and have a tracking error with zero expected value.
Result 11.1: Whenever a tracking portfolio for the future cash flows of a project generates tracking
error with zero systematic (or factor) risk and zero expected value, the market value of the tracking
portfolio is the present value of the project’s future cash flows.
It is possible to estimate a tracking portfolio without knowing the expected cash flows when there is
(almost) perfect tracking with a combination of risk-free asset with market portfolio or factor portfolios.
Linking Financial Asset Tracking to Real Asset Valuation with the SML
The security market line can be used to define the proper mix of assets in the tracking portfolio.
Positive (above SML) and negative NPV-projects (below SML) tend towards the SML (plotted graph
with beta of tangency portfolio and mean return on the axis) because the prices of the claims adapt.
The risk-adjusted discount rate method discounts at the cost of capital: the expected return that
investors require for holding an investment with same risk.
Defining and Implementing the Risk-Adjusted Discount Rate Method with Given Betas
Result 11.2 To find the present value of next period’s cash flow using the risk-adjusted discount
rate method:
Formula:
Because the beta is often unknown, a comparison approach is usually used: estimate of beta by
analyzing comparison securities.
The Tracking Portfolio Method is Implicit in the Risk-Adjusted Discount Rate Method
The discounted future cash flow is equal to the cost of the tracking portfolio’s cash flows while the
beta represents the proportion of the tracking portfolio allocated to the market portfolio (= tangency
portfolio).
In order to make appropriate beta risk comparisons, adjustments for leverage are necessary.
In an all-equity firm the market value of assets (A) equals the market value of equity (E) and
therefore: σA = σE, or βA = βE.
In a levered firm, the market value of assets (A) equals the sum of the market values of equity (E)
and debt (D): A = D + E
The Right-Hand Side of the Balance Sheet as a Portfolio
Viewing the right-hand site of the balance sheet as a portfolio, the weight of debt is D/(D+E) and the
weight of equity is E/(D+E). Formulas for this portfolio:
and
If debt is risk-free, σD and βD are zero. The formulas can be restated to:
and
Result 11.3 Increasing the firm’s debt (raising D and reducing E) increases the (beta and standard
deviation) risk per dollar of equity investment. It will increase linearly in the D/E ratio if debt is risk
free.
and
Debt has two types of risk: default risk (credit risk) and interest rate risk, which is the risk of changes
in long-term interest rates. Default free debt still has interest risk; risk-free debt is necessarily short-
term because it doesn’t have a interest rate risk. When βD>0, the formulas are:
and
The beta of equity increases linearly with the leverage ratio D/E until default is possible: because
debt holders bear part of the risk, the beta of equity increases diminishingly (see Exhibit 11.4, 382).
The capital structure (mix of equity and debt) doesn’t influence the cash flows, but leverage changes
the variance in equity value. The cost of equity for a firm is the expected return required by investors
to induce them to hold the equity. The cost of equity increases linearly with the leverage ratio.
Result 11.4: The cost of equity, , increases as the firm’s leverage ratio
D/E increases. It will increase linearly in the ratio D/E if the debt is default-free and if , the
expected return of the firm’s assets, does not change as the leverage ratio increases.
The return of debt (cost of debt) equals rf for moderate leverage ratios. If the amount of debt
becomes extreme, the expected return of debt increases because debt holder bear part of the risk of
the assets. This is shown in Exhibit 11.5 (384).
11.4 Implementing the Risk-Adjusted Discount Rate Formula with Comparison Firms
Using the beta of another firm to estimate an unknown beta, it is important the company not only has
similar lines of business, but also has the same leverage ratio.
Adjustment of comparison firm’s beta is necessary if leverage differs. Because of the absence of
taxes, the Weighted Average Cost of Capital and the Unlevered Cost of Capital are identical to .
In case of risk-free debt, the beta of assets can be calculated by:
Instead of the beta of assets, it is also possible to calculate the expected return of assets. If multiple
comparison firms are used, an average of their betas/expected returns is used. If some firms are
less comparable, a weighted average can be used.
The Arbitrage Pricing Theory (APT) should be used when a combination of factor portfolios, instead
of market portfolio, is the tangency portfolio. The multifactor APT formula to calculate the PV:
APT and CAPM may have very different outcomes. Factors that may be included in the APT are
short-term and long-term inflation, interest rates, premium for default risk and monthly GDP.
Cost of Capital Computed with Alternatives to CAPM and APT: Dividend Discount Models
CAPM and APT require market information that is hard to get. The dividend discount model (also
called Gordon Growth Model) determines stock price if dividends grow at constant rate by:
, rearranged to:
S0 = current stock price; div1 = dividend one year from now; g = growth rate of dividends;
The dividend yield is often stable, the growth rate can be estimated by analyst forecasts. The growth
rate can also be identified by the plowback ratio formula:
ROE = book return on equity (dividend divided by mid-year book equity) for new assets
Implicit assumptions of the dividend discount model are: unbiased earnings growth forecasts,
earnings growth forecasts and stock value are based on same information, earnings and dividends
grow at same constant rate forever.
1.
2.
New projects are often from a different line of business or have a different risk (like more
operating leverage).
Growth opportunities or growth options cause high betas because their value depends on the
(changing) health of the economy. This makes the (comparison) firm’s beta useless.
Practitioners often use a four-step approach: (1) estimate comparison firm’s equity beta, (2)
compute the expected return with CAPM or APT, (3) obtain cost of capital by adjusting for
leverage and taxes, and (4) use the cost of capital as single discount rate. However, different
rates should be used for different years. It is unclear if the short-term or long-term risk-free rate
should be used, however, the one that provides the smallest tracking error should be chosen.
This problem can be solved by using the APT-method including the three factors (short-term risk-
free, long-term risk-free and market portfolio). Valuation errors can also be made by ignoring the
timing of cash flows: risk of cash flows may differ in time. Therefore, the geometric mean should
be calculated for establishing the rate.
If no comparison firm or portfolio exists, scenarios can be used to calculate the beta. However,
this provides a wrong beta because the gross return (return + 100%) of the tracking portfolio
exceeds the gross return of the project.
Result 11.5: The betas of the actual returns of projects equals the project’s
profitability index times the appropriate beta needed to compute the true present
value of the project. Since the profitability index exceeds 1 for positive NPV
projects and is below 1 for negative NPV projects, this error in beta computation
does not affect project selection in the absence of project selection constraints.
Result 11.5 is problematic in mutually exclusive projects: in that case, only the NPV-method
(instead of the profitability index) is right.
Another, sometimes easier, method to discount risky cash flows is the Certainty Equivalent Method.
The certainty equivalent method first obtains the certainty equivalent of the cash flows (somewhere
between the worst case scenario and the weighted average), then it discounts the certainty
equivalents at the risk free rate. The risk-adjustment occurs in the cash flows (instead of the discount
rate as in the risk-adjusted discount-rate methods).
Result 11.6: To obtain a certainty equivalent, subtract the product of the cash flow beta and the
tangency portfolio risk premium form the expected cash flow; that is:
with
CE(CF) is the certainty equivalent of the cash flow. b is the cash flow beta (not risk beta!). If scenario
estimations are the only method to calculate risk, the certainty equivalent method is the best method.
Result 11.7: The present value of next period’s cash flow, can be found by (1) computing the
expected future cash flow E(CF) and its beta, (2) subtracting the product of this beta and the risk
premium of the corresponding tangency portfolio, and (3) dividing by (1 + risk-free return); that is:
There’s a relation between cash flow betas b and return betas β: PV = b/β.
Calculating the present value with the certainty equivalent method: (1) calculate (RM - rf) by
subtracting rf from the weighted average of market returns and also calculate its variance, (2)
calculate the incremental cash flow, (3) calculate b, the covariance between the cash flows and the
market return, and (4) compute the present value with the formula.
Instead of using factors in the discount rate, the APT can also use factors in the cash flows:
The relation between the Certainty Equivalent Formula and the Tracking Portfolio Approach
The certainty equivalent method results in the same present value as the tracking portfolio approach
because the beta of the cash flow, b, is derived from the tracking portfolio approach.
Result 11.8 If it is possible to estimate the expected future cash flow of an investment or project
under a scenario where all securities are expected to appreciate at the risk-free return, then the
present value of the cash flow is computed by discounting the expected cash flow for the risk-free
scenario at the risk-free rate.
The risk-free scenario method discounts future cash flows with the risk-free rate.
A reasonable procedure for estimating the cash flow as a multiple of the company’s future stock
price and compute what the price of the company’s stock and the project cash flow would be when
the company’s stock appreciates at a risk-free rate. Also stock of another company, or a portfolio of
stocks, can be used.
Analysts often provide conservative estimations, which are (imprecise) certainty equivalents.
Forward Prices
Forward prices can be used to transform risky cash flows to risk-less cash flows.
Tracking portfolios using forward contracts may be easier to use the risk-adjusted discount rate
approach.
Chapter 13 Corporate Taxes and the Impact of Financing on Real Asset
Valuation
Companies can create value with their capital structure, for example with the interest tax shield and
subsidized loans. This influences the two methods to determine a project’s NPV:
Result 13.1: Analysts use two popular methods to evaluate capital investment projects: the APV
method and the WACC method. Both methods use as their starting points the unlevered cash flows
generated by the project, assuming that the project if financed entirely by equity. The APV method
calculates the net present value (NPV) of the all-equity-financed project and adds the value of the
tax (and any other) benefits of debt. The WACC method accounts for any benefits of debt by
adjusting the discount rate.
The APV method is superior because of its flexibility by the valuation by components (value of
project separated from value of tax shield), however, the WACC method is widely used and
understood.
This chapter will ignore personal taxes and take the debt capacity (amount of new debt financing the
firm will add) as given.
Unlevered cash flows are not influenced by the amount of debt used.
The unlevered cost of capital (rUA) is the expected return on the equity of the firm if the firm is
financed entirely with equity.
The WACC is a weighted average of the after-tax expected return paid by the firm on its debt
and equity.
The concepts leads to the same outcome if there is no debt tax shield.
The tax shield should be included in the analysis when comparison firms are used to identify a
project’s cost of capital.
The Risk of the Components of the Firm’s Balance Sheet with Tax-Deductible Debt Interest
The balance sheet of a levered firm with a tax deductible debt interest:
Unlevered assets (UA): the present value of the unlevered cash flows
Debt tax shield (TX): the present value of the financing subsidy.
Viewing the firm’s value (A) as a portfolio of unlevered assets (UA) and the tax shield (TX) implies:
and
The present value of the tax shield in perpetuity (Hamada model assuming lending at risk-free rate):
with TC = corporate tax rate
This implies the asset beta decreases when debt increases because the tax shield is risk
free. It has three assumptions: (1) debt is perpetual, (2) debt is default-free and pays risk-free
rate, and (3) face value and tax rate do not change.
This implies the beta of equity increases less when the tax rate is larger.
The APV method allows separate valuing of different sources of value creation.
Debt Capacity
Debt capacity is limited by bankruptcy costs or frictions on the capital market. A project’s debt
capacity depends on characteristics of the project and of the firm.
The APV Method Is Versatile and Usable with Many Valuation Techniques
The APV is suitable for more complicated tax situations, like increasing debt in a later phase of the
project.
When discounting risky debt tax shield, the tax paid annually is multiplied by its expected utilization
and discounted by required return on debt (according to the CAPM formula).
The APV method can also be combined with the certainty equivalent method: the yearly tax shield is
added to the yearly certainty equivalent cash flows and discounted by the risk-free rate.
The APV method can further be combined with the real options approach: by multiplying probabilities
and outcomes, discounted at risk-free rate, the NPV of a project is determined.
Result 13.2: Firms can easily use the APV method with a variety of valuation methods, including
those that make use of risk-adjusted discount rates, certainty equivalents, ratio comparisons and
real option approaches.
Often the WACC of the company is used to discount a project, to simplify evaluations.
Valuing a Business with the WACC Method when a Debt Tax Shield Exists
The cost of equity (rE) is usually calculated with the CAPM or the APT.
WACC Components: The Cost of Debt Financing
If debt is risky, the promised rate of return (yield) is larger than the expected rate of return (rD). This
overestimation is partially offset by the underestimation of (1-TC) because the tax shield can not
always be fully used. The TC that should be used in the WACC, is calculated by:
1. with the probability of default (here: p), the promised yield and the recovery rate (part of debt
repaid on default):
2. with the CAPM-rate, the promised yield, tax rate and probability of
utilization:
Determining the Cost of Debt and Equity When the Project is Adopted
The required rates for return are the rates at the time the firm adopts the project.
Result 13.3 In the absence of taxes and other market frictions, the WACC of a firm is independent
of how it is financed (Exhibit 13.4, 481).
The absence of taxes makes the financing mix irrelevant for valuation.
The Effect of Leverage on a Firm’s WACC with a Debt Interest Corporate Tax Deduction
Result 13.4 When debt interest is tax deductible, the WACC will decline as the firm’s leverage
ratio, D/E, increases (Exhibit 13.5, 483).
In the Hamada model (rD=rF, βTX=0 and TX=TCD), the addition of taxes results in:
and (adjusted cost of capital formula)
The Miles/Ezzell model is more useful than the Hamada model when debt is dynamic (instead of
fixed) and risk-free. This implies βTX=βUA and the formulas become:
and
The appropriate discount rate for a project must reflect the risk and debt capacity of the project
rather than the firm. The measure for the cost of capital of a project is the firm’s marginal cost of
capital, which reflects the risk of the project (not the firm). The WACC of the whole firm can only be
used for a project when betas are equal and both contribute the same proportion to the firm’s debt
capacity.
Till now, every decision was based on total firm value. However, sometimes this conflicts with
maximizing the value of equity.
Positive NPV Projects Can Reduce Share Prices When Transfers to Debt Holders Occur
Some firms can not lend at risk-free rates for a riskless project, therefore positive NPV-projects will
be rejected in the case the project yield is lower than the interest rate demanded by debt holders.
Although such projects will still enlarge a firm’s total value, shareholder value decreases.
The NPV of a project to equity holders can best be calculated with the real options approach. With
this method, the possible transfer of value from equity to debt holders can also be computed.
Result 13.5 In the absence of default, the present value of a project’s future unlevered cash flows,
discounted at the WACC, is identical to the present value of cash flows to equity holders discounted
at the cost of equity. Hence, in the absence of default, the NPVs generated with both present value
calculations select and reject the same projects. When debt default is a significant consideration,
projects that increase firm value may not increase the values of the shares held by equity holders
and vice versa. However, in these cases it is more appropriate to analyze the values of cash flows
with the real options approach.
The Modigliani-Miller Theorem: if the capital structure has no effect on the total cash flows that a firm
can distribute to its debt and equity holders, the decision also will have no effect on the total value of
the firm’s debt and equity. Due to the interest tax deductibility, this theorem doesn’t hold.
The firm can be seen as a pie, consisting of two parts (equity and debt, in accordance with MM-
Theorem) or three parts (equity, debt and government).
Future
Current Future Current
Cash
Value Cash Flow Value
Flow
Debt 0 0 (1+rD)D D
Equity X VU X - (1+rD)D EL
Total X VU X VL = D+EL
According to Modigliani-Miller Theorem, VU must equal D+EL, else arbitrage opportunities exist. For
example, when a shareholder sells its 10%-share in an all-equity firm and buys a 10%-share in
equity and debt of a levered firm with the same cash flows, the pay-out is: .1[X - (1+rD)D]
+ .1(1+rD)D - .1X
Because pay-outs are equal and no arbitrage is possible, the total value of the firm should be equal.
Result 14.1 Assume: (1) a firm’s total cash flows to its debt and equity holders are not affected by
how it is financed, (2) there are no transaction costs, and (3) no arbitrage opportunities exist in the
economy. Then the total market value of the firm, which is the same as the sum of the market values
of its debt and equity, is not affected by how it is financed.
The key assumption (total cash flows not affected by capital structure) is important: it ignores the
debt tax shield. The second assumption (no transaction costs) may have a large influence:
transaction costs can make tracking impossible. The third assumption (no arbitrage) is commonly
used: equilibrium prices cannot provide opportunities for riskless arbitrage profits.
14.2 How an Individual Investor Can “Undo” a Firm’s Capital Structure Choice
Shareholders can undo the effect of a change in capital structure by making offsetting changes to
their own portfolio. Without transaction costs, the shareholder is indifferent in changes.
Until now, it was assumed all debt was riskless. When this is no longer true, it impacts the MM-
model.
The MM-Theorem permits bankruptcy, but no bankruptcy costs. If debt is risky, the pay-out to
shareholders and debt holders (also in the MM-Theorem) change.
Result 14.2 Assume (1) a firm’s cash flow to debt and equity holders is unaffected by how it is
financed, (2) no transaction costs, and (3) no arbitrage opportunities exist. Then, if a firm’s existing
debt holders have a senior claim in the event of bankruptcy, both the firm’s stock price and the value
of existing senior debt claims are unaffected by changes in the capital structure.
Result 14.3 If existing debt holders do not have a senior claim in the event of bankruptcy, a new
debt issue can decrease the value of existing debt. Under the three basic assumptions, the loss to
the old debt holders would be offset by a gain to the equity holders, leaving the total value of the firm
unaltered by this type of capital structure change.
In practice, the MM-Theorem doesn’t hold especially because the debt tax shield. This paragraph
has three assumptions: (1) corporate taxes, (2) tax-deductible interest expenses, and (3) no
personal taxes.
With corporate taxes, the after-tax payments to debt and equity holders in year t are:
Ct = pay-out to shareholders + pay-out to debt holders
If a firm’s yearly tax savings, rDTCD, are static and perpetual, the PV of the tax shield is TCD.
Result 14.4 Assume cash flows unaffected by a change in capital structure, no transaction costs
and no arbitrage opportunities. With corporate taxes at the rate TC, but no personal taxes, the value
of a levered firm with static risk-free perpetual debt is the value of the equivalent unlevered firm plus
the product of the corporate tax rate and the market value of the firm’s debt:
VL = VU + TCD
Result 14.5 Assume cash flows unaffected by a change in capital structure, no transaction costs
and no arbitrage opportunities. With corporate taxes at the rate TC, but no personal taxes, a firm’s
optimal capital structure will include enough debt to completely eliminate the firm’s tax liabilities.
In general, personal taxes on debt are larger than personal taxes on equity (TD > TE).
Because tax rate on debt income differs per individual, preferences for debt or equity differ among
investors.
Result 14.5 Assume cash flows unaffected by a change in capital structure, no transaction costs
and no arbitrage opportunities. If investors all have personal tax rates on debt and equity income of
TD and TE and if the corporate tax rate is TC, then the value of a levered firm exceeds the value of an
otherwise equivalent unlevered firm by TgD; that is
with
Firms will be indifferent about their debt level if Tg is zero, expressed in the equation:
If this equation holds, investors are indifferent between holding debt and zero-beta equity if:
rD(1 - TC) = rE
Companies can not always utilize their interest tax shield completely, for example due to non-debt
tax shields. Then, the optimal mix of debt and equity depends on the relation between X and rDD:
Result 14.7 Assume there is a tax gain from leverage, but the taxable earnings of firms are low
relative to their present values:
With riskless future cash flows, firms will want to use debt financing up to the point where they
eliminate their entire corporate tax liabilities, but they will not want to borrow beyond that point.
With uncertainty, firms will pick the debt ratio that weighs the benefits associated with the debt
tax shield when it can be used against the higher cost of debt in cases where the debt tax shield
cannot be used.
Firms with more non-debt tax shields are likely to use less debt financing.
Most effective marginal tax rates (the actual marginal tax rate for a company) are often below TC.
14.6 Taxes and Preferred Stock
Preferred stock is comparable to a bond although it is junior to debt. Dividends on preferred stock
are not tax deductible, on contrary to coupon payments of bonds. However, corporate holders are
partially exempted of preferred dividend taxes, therefore the yield on preferred stock is usually less
than the yield on bond. Firms that are not able to deduce interest (due to a lack of taxable earnings),
can decrease the cost of capital by issuing preferred stock.
The largest shareholders are usually tax-exempt investors (risk-averse, so leverage-neutral) and
individuals with high personal tax rates (risk-neutral, so in favor of high leverage), this can create a
conflict of interests. This conflict is solved by tax-free municipal bonds because they provide the
possibility for the taxed individual to obtain substantial higher after-tax yields.
(Expected) inflation is directly related to interest rates. An increase in inflation increases the leverage
tax gain and changes the optimal leverage ratio.
Firms generating large taxable earnings before interest and taxes should use a large amount of debt.
In reality, there is a negative relation between EBIT and debt ratios because firms rarely issue new
equity, implying (1) non-debt tax shields are positively correlated with the use of debt financing, and
(2) poorly performing firms accumulate debt to meet their expenses.
How the Tax Reform Act of 1986 Affected Capital Structure Choice
Firms loosing more of their non-debt tax shields due to the act, increased their debt levels more.
The lessor passes on the costs to the lessee. The lease payment is computed by:
1 - TC
If the depreciation deduction equals the economic depreciation, the lease payment is equal to the
debt repayment and the interest, which is equal to the cost of owning. However, if the lessor can
take advantage of accelerated depreciation and the lessee cannot (or less, because it has a low
marginal tax rate), leasing is cheaper than buying. Only true leases are tax-deductible, requiring a
shared risk which results in an incentive problem.
Result 14.8 For low tax bracket investors, it is often cheaper to lease an asset than to buy it.
Dividend policy: a firm’s policy about the distribution of cash to its shareholders. According to the
Miller-Modigliani irrelevance theorem, dividend policy is irrelevant. This involves the policy of paying
a dividend versus repurchasing shares, not reinvesting or paying out.
The dividend payout ratio (ratio of dividends to earnings) declined in the last quarter of the
20th century, but share repurchases increased after restrictions on dividend payouts.
Dividend yields and dividend payout ratios differ per company and industry, depending on their
growth opportunities.
15.2 Distribution Policy in Frictionless Markets
Dividend policy is strongly influenced by market frictions resulting in considerably different outcomes.
Result 15.1 Consider the choice between paying a dividend and using an equivalent amount of
money to repurchase shares. Assume (1) no tax considerations, (2) no transaction costs, and (3)
investment, financing and operating policies are held fixed. Then the choice between paying
dividends and repurchasing shares is a matter of indifference to shareholders.
The dividends received by a shareholder when there’s a payout are equal to the increase in share
price when there’s a repurchase. The new share price and number of shares repurchased is
established by solving two equations:
and
Result 15.2 Consider the choice between paying out earnings to shareholders versus retaining the
earning for investment. Assume (1) no tax considerations, (2) no transaction costs, and (3) this
choice does not convey information to shareholders. Then a dividend payout will either increase or
decrease firm value, depending on whether there are positive net present value (NPV) investments
that could be funded by retaining money within the firm. If there are no positive NPV investments,
the money should be paid out.
Imputation system: system under which investors who receive taxable dividends get a tax credit for
part or all of the taxes paid by the corporation. Classical tax system: system in which dividends are
taxed as ordinary income and capital gains are generally taxed at a lower rate than ordinary income.
How Taxes Affect Dividend Policy
Result 15.3 In the U.S., taxes favor share repurchases over dividends. The gain associated with a
share repurchase over a cash dividend depends on:
Difference between capital gains rate and tax rate on ordinary income
Tax basis of shares (historical share purchasing price)
Timing of sale of shares (taxing under long-term capital gains rate demands a minimum holding
period)
Theoretically, individuals can avoid dividend taxation by lending money and investing it in tax-
deferred insurance annuities. The interest on the loan is tax-deductible, deferring taxes until annuity
payout.
Dividend Clienteles
Different dividend payout ratios appeal to different investor clienteles: different groups of investors
with different tastes for receiving dividend income. A firm’s dividend yield is related to its investor’s
marginal tax rate (for example, tax-exempt investors prefer dividends to minimize transaction costs).
The dividend taxes for individuals are much larger than the transaction cost for tax-empted investors,
therefore, it is quite unclear why corporations pay out dividends.
According to previous theory, stocks with higher dividend yields should offer higher expected returns
to compensate for their tax disadvantage.
There is a relation between stock price movements and the ex-dividend dates (possessors of shares
before this date are entitled to dividend): the smaller the dividend, the smaller the relative price drop
on the ex-dividend date. This may prove the clientele effect, but may also be caused by the relatively
large transaction costs.
Result 15.4 Stocks with high dividend yields are fundamentally different from stocks with low
dividend yields in terms of their characteristics and their risk profiles. Therefore, it is nearly
impossible to assess whether the relation between dividend yield and expected returns is due to
taxes or risk.
Taxes and transaction costs can distort investment and financing choices.
The distinction between internally and externally generated equity is important if distributed earnings
are taxed at high personal rates.
For taxable investors, reinvesting cash flows into the firm into projects with (very) low returns may be
beneficial to receiving dividends and reinvesting them: dividends are taxed while reinvestments are
not. Investors prefer retained earnings over a cash dividend if:
(1 - TC) × (pretax return within corporation) > (after personal tax return outside corporation)
Result 15.5 Tax-exempt and tax-paying shareholders agree about which projects a firm should
fund from external equity issues, but may disagree about which projects should be financed from
retained earnings. In particular:
Tax-exempt shareholders require same return for internally financed projects as for externally
Tax-paying shareholders prefer lower returns for internally financed projects if the alternative is
paying taxable dividends or repurchasing their shares
Result 15.6 The combination of the corporate tax deductibility of interest payments and the
personal taxes on dividends (and share repurchases) implies that:
Pecking order of financing choices: 1st retained earnings, 2nd debt, and 3rd issuing outside equity.
Direct bankruptcy costs: costs of the legal process involved in reorganizing a bankrupt firm. Indirect
bankruptcy costs: costs not directly related to a reorganization that arise among financially
distressed firms or firms close to bankruptcy. Indirect bankruptcy costs exist because firms tend to
harm non-financial stakeholders during financial distress. Firms operating solely in the interest of
equity holders may reject positive NPV-projects or accept risky projects. The conflict of interests
between shareholders and debt holders is solved by covenants and convertible debt. This chapter
assumes: risk-neutrality, no bankruptcy costs, no taxes, and risk-free rate of zero.
16.1 Bankruptcy
Chapter 7 bankruptcy: liquidation of the firm by selling its assets. Proceeds are distributed according
to the absolute priority rule: a more senior claim must be paid completely before a more junior claim
(seniority ranking: secured debt, senior unsecured debt, junior unsecured debt, shareholders).
The direct costs of bankruptcy (about 2-3%) add little to a firm’s borrowing costs because (1) this is a
percentage of an already diminished firm value and (2) it is multiplied by the probability of
bankruptcy and discounted. The default premium: difference between promised bond yield and yield
on a default-free bond, reflecting the probability and cost of a firm’s bankruptcy.
Result 16.1 Debt holders charge an interest premium that reflects the expected costs they must
bear in the event of default. Therefore, equity holders indirectly bear the expected costs of
bankruptcy and must consider these costs when choosing their optimal capital structures.
Financial distress costs: indirect bankruptcy costs having a large impact on a firm’s operations,
resulting in an increased preference for equity.
Maximizing the value of equity is not necessarily maximizing total value of the firm. Strategies that
decrease debt value while total firm value remains unchanged (so, increasing equity value) exist.
Result 16.2 Firms acting to maximize their stock prices make different decisions when they have
debt in their capital structures than when they are financed completely with equity.
Lenders expect this opportunistic behavior and demand larger interest rates.
Categories of investment strategies resulting from debt holder – equity holder conflicts:
Result 16.3 Selecting projects with positive net present values can at times reduce the value of a
levered firm’s stock.
Result 16.4 Firms that have existing senior debt obligations may not be able to obtain financing for
positive NPV investments.
Result 16.5 With risky debt, equity holders have an incentive to pass up internally financed
positive NPV-projects when the funds can be paid out to equity holders as dividend.
Result 16.3 may be caused by a borrowing rate above the discount rate (firm’s borrowing rate >
project’s borrowing rate), causing positive total cash flows but negative cash flows to equity holders.
Result 16.4 may be caused by an expected cash flow too low to pay out both senior debt (for sunk
costs, like R&D) and junior debt (to finance the positive NPV-project). This problem wouldn’t exist if
original lenders provided the new debt also, but this gives a free-rider problem if debt is dispersed.
Result 16.5 is caused by a future debt repayment leaving less value for equity holders. By rejecting
positive NPV-projects (harming debt holders) and paying out dividends, equity holders benefit while
debt holders are disadvantaged. This is solved by covenants, which can be written in two days: (1)
specifying a firm’s future actions, which is very difficult, and (2) restricting the payout to equity
holders, which may lead to avoiding behavior.
Result 16.6 Firms with large amounts of debt tend to pass up high NPV projects in favor of lower
NPV projects that pay off sooner.
Shareholders are willing to select short-term projects if this increases the expected cash flows to
equity holders, by harming the interest of debt holders.
Debt provides an incentive to take on unnecessary risk because equity holders can realize an
unlimited upside while their risk is limited to their entire investment. The option pricing model is
applicable.
Result 16.7 The equity holders of a levered firm may prefer a high-risk, low (or even negative)
NPV project to a low-risk, high NPV project.
Debt holders will incorporate risky projects in the face level of their debt, thereby averting the costs
to shareholders (which are sometimes forced to take the risky project to realize a positive NPV).
Result 16.8 With sophisticated debt holders, equity holders must bear the costs that arise
because of their tendency to substitute high-risk, low NPV projects for low-risk, high NPV projects.
Deposits insured by the U.S. government increased the asset substitution problem in the past.
Result 16.9 Firms with the potential to select high-risk projects may be unable to obtain debt
financing at any borrowing rate when risk-free interest rates are high.
By increasing the interest rates, lenders also adversely affect a firm’s project choice. If raising the
interest rates results in a choice for the more risky project, banks are unwillingly to lend money.
Liquidations costs are the different between the firm’s going concern value (NPV of cash flows
generated by continuing operations) and its liquidation value (value of firm by selling its assets). If
the going concern value exceeds the liquidation value, both debt and equity holders prefer a
reorganization and continuation of operations. If the face value of debt exceeds the liquidation value,
shareholder are in favor of continuing operations.
Result 16.10 Since debt holders have priority in the event of liquidation, they have a stronger
interest in liquidating the assets of a distressed firm than the firm’s equity holders, who profit from
the possible upside benefits that may be realized if the firm continues to operate. As a result, a firm’s
financial structure partially determines the conditions under which it liquidates.
If a firm has debts with different seniority, junior debt holders may also be reluctant to liquidate and
even willingly to provide additional debt. Equity holders and junior creditors have option-like claims,
creating an incentive to put more money in a distressed firm.
16.3 How Chapter 11 Bankruptcy Mitigates Debt Holder–Equity Holder Incentive Problems
Debtor-in-possession (DIP) financing: new debt obtained under Chapter 11 bankruptcy. Chapter 11
allows additional lending to fund investments that are required for its continued operations.
Result 16.11 In Chapter 11 bankruptcy, firms are able to obtain debtor-in-possession (DIP)
financing. To some extent, this provision of the bankruptcy code mitigates the debt
overhang/underinvestment problem. However, the provision also may allow some firms to continue
operating when they would be better off liquidating.
16.4 How Can Firms Minimize Debt Holder–Equity Holder Incentive Problems?
Result 16.12 The adverse effects of debt financing on a firm’s unlevered cash flows arising from
debt holder–equity holder conflicts may be mitigated by using:
protective covenants
bank debt and privately placed debt
short-term debt instead of long-term debt
convertible bonds
project financing
properly designed management compensation contracts
Protective Covenants
Violating a covenant leads to technical default, allowing debt holders direct repayment. However,
covenants are much weaker than expected given the potential conflicts because costs of limiting
management’s flexibility may not exceed benefits of limiting bondholders’ risk. More risky,
noninvestment-grade debt covenants often include: issuance of further debt, changes in control,
dividend limitations, asset sales, maintenance, and insurance provision. Covenants cannot solve all
problems, like rejecting positive NPV-projects, or reluctance to liquidate.
The use of bank debt resolves the free-rider problem of the debt-overhang problem. Bank and
privately placed debt have a better ability to state and monitor covenants, solving the debt overhang
and asset substitution problem. However, bank debt has certain costs: (1) banks charge their costs,
(2) banks usually provide extra debt at the same marginal rate which may be too low, and (3) a hold
up problem. The hold up problem: negative signaling to other capital sources if banks charge rates
above the market rate to exploit its position.
Short-term debt is less sensitive than long-term debt to changes in investment strategy, reducing
debt holder–equity holder conflicts. Short-term debt mitigates the debt overhang problem because
rates are frequently renegotiated. For the same reason, the asset substitution problem is also
mitigated. However, short-term debt also increases the bankruptcy risk caused by interest rate
changes.
Security Design: The Use of Convertibles
Convertible debt decreases the conflicts between debt and equity holders. Theoretically, it is
possible to design a convertible bond insensitive to changes in firm’s volatility. Empirically, highly
levered, high-growth firms are most likely to issue convertible bonds.
Project financing: capital to finance an investment project for which both the project’s assets and the
liabilities attached to its financing can affectively be separated from the rest of the firm. The project is
financed with non-recourse debt: the parent is not responsible for the project’s debt. Project
financing may mitigate the underinvestment problem, but may increase the asset substitution
problem.
Naturally, managers are more aligned with the interests of debt holders, because they are risk
averse (their wealth is tied up to the firm) and have an incentive to overinvest (to gain prestige). To
maximize the current firm value, firms need to compensate managers in ways that make them
sensitive to the welfare of both debt holders and equity holders.
Debt financing distorts investment incentives. Therefore, firms with substantial investment
opportunities have little debt and prefer short-term debt.
Poor investment opportunities may cause firms to become highly levered, while a high leverage
might cause firms to invest less, especially in less in non-core businesses.
In Japan, banks increase control by holding both debt and equity. Growth firms with close bank
relationships have relatively higher debt ratios.
Manager decisions may deviate from choices to maximize firm value because (1) to benefit
personally or (2) to serve a broader community than just shareholders, especially employees. The
corporate investment strategy is determined by managers and influenced by large shareholders.
The separation of ownership (shareholders) and control (management) causes conflicting interests.
Managers see themselves as representatives of investors, customers and suppliers, and employees.
Result 18.1 Management interests are likely to deviate from shareholder interests in a number of
ways. The extent of this deviation is likely to be related to the amount of time managers have spent
on the job and the number or shares they own.
Share prices sometimes react favorably to CEO retirements or deaths, probably because the new
CEO (with fewer ties to the firm) is more likely to take tough decisions.
Why Shareholders Cannot Control Managers
Result 18.2 Firms with concentrated ownership are likely to be better monitored and thus better
managed. However, shareholders with large equity stakes may be inadequately diversified. The
costs of less diversification are bore by large shareholders, while all shareholders benefit. Therefore,
ownership is likely to be less concentrated than it would be if management efficiency were the only
consideration.
Shareholders wanting to change corporate strategy, must stage a proxy fight, which gives high
individual costs while benefits are shared (so, a free-rider problem). U.S. insurance companies and
mutual funds are not allowed to exert power over a firm, but pension funds are and also start to do
so.
management incentive plans, more active institutional shareholders, active takeover market
changing SEC regulations disclosing more information
more effective corporate boards (smaller and more outside directors)
more CEO replacements after poor performance
Corporate governance problems differ across countries and over time: the legal protection for
outside shareholders has a large impact on the stock market.
Result 18.3 Entrepreneurs may obtain a better price for their shares if they commit to holding a
larger fraction of the firm’s outstanding shares. The entrepreneur’s incentive to hold shares is higher
for those firms with the largest incentives to ‘consume on the job’ and is also related to risk aversion
Management Shareholding and Firm Value: The Empirical Evidence
The optimal size of management’s holdings is 5%, based on market-to-book value ratios, but this is
a poor measure. Close-end mutual funds (publicly traded mutual funds with a fixed number of shares
bought and sold on the open market) measure the value created by management easier than open-
end mutual funds (publicly traded mutual funds bought and sold directly from the fund at their net
asset values), this provides the same result: large shareholders decrease total fund value.
When self-interested managers control most of the firm’s investment decision, they tend to:
make investments that fit the manager’s expertise (to become indispensable)
make investments in visible/fun industries
make investments that pay off early
make investments that minimize the manager’s risk and increase the firm’s scope
Result 18.4 Managers may prefer investments that enhance their own human capital and
minimize risk, implying: (1) preferring larger, more diversified firms, and (2) preferring investments
that pay off quickly though have lower NPVs.
Therefore, we might expect to find more concentrated ownership and more managerial
discretion in firms facing more uncertain environments.
Increasing debt forces a self-interested management to act towards shareholder interest because
there is less margin for error.
Result 18.7 Large debt obligations limit management’s ability to use corporate resources in ways
that do not benefit investors.
Result 18.8 A firm’s debt level is a determinant of how much the firm will invest in the future and it
can be used to move the firm toward investing the appropriate amount. In general, however, capital
structure cannot by itself induce managers to invest optimally.
Overinvestment/underinvestment problems can be solved by using a single bank for debt: debt is
renegotiable, the free-rider problem of monitoring is reduced, and information has not to be revealed.
Suppliers of private equity monitor management because (1) they invested substantially, (2) their
shares are less tradable, and (3) they have experts advising, consulting and monitoring.
There is a trade-off between output-based compensation and bearing uncontrollable risk. Agency
problems are based on uncertainty and asymmetric distribution of information. There has been a
tendency to replace input-measurement to output-measurement (actual performance). Agents’
compensation contracts should incorporate all relevant factors outside the agents’ control. Agency
costs: difference between actual firm value and hypothetic value in a more perfect world.
Result 18.9 Agency problems partly arise because of imperfect information and risk aversion.
Agency costs thus can be reduced by improving the flow of information and by reducing risk. To
minimize the risk borne by managers, optimal compensation contracts should eliminate as much
extraneous risk as possible.
Executive compensation is partially fixed, partially based on profits, and partially based on stock
price. It seems the direct pay-for-performance sensitivity is surprisingly low, but this may be caused
by compensation plans over multiple years. Pay-for-performance sensitivity differs across firms and
depends on firm size and management discretion.
Executive compensation became more performance sensitive, almost solely by stock option grants.
Result 18.10 Relative performance contracts: compensation system rewarding managers for
performing better than either the entire market or than the firms in their industry. Advantage: the
contract eliminates the effect of some of the risks that are beyond the manager’s control.
Disadvantage: the contract may cause firms to compete too aggressively, which would reduce
industry profits.
Result 18.11 Stock-based compensation motivates managers to improve share prices, but stock
prices also react to changes outside manager’s control and only partially reflect the performance of
managers of individual business unites. A cash flow-based compensation plan that appropriately
adjusts for capital costs may provide the best method for motivating managers in these cases.
Compensation Issues, Mergers, and Divestitures
One of the reasons for a spin off (transform a division into a new company and distribute the new
company’s shares to the firm’s existing shareholders) or a carve out (do an IPO of a division) may be
better performance measurement. In contrast, mergers may adversely affect managerial incentives.
Result 18.12 Improved management incentives provide one motivation for corporate spin-offs and
divestitures. Similarly, conglomerate mergers may weaken the incentives of executives at the
various divisions.
Merger: transaction that combines two firms into one new firm. Mergers often still have an acquiring
firm (bidder initiating the offer) and a target firm (acquired firm receiving the offer). Acquisition: the
purchase of one firm by another firm. According to the MM Theorem, the value of a firm doesn’t
change if its securities are repackaged, as long as cash flows don’t change. However, the bidder is
usually willing to pay a takeover premium (difference between stock price and the amount offered).
M&A activity increased considerably last decades due to a number of reasons. The largest mergers
before 2000 are all horizontal mergers.
There are three different categories of M&A transactions: strategic, financial and conglomerate
acquisitions. Acquisitions can also be classified into friendly and hostile. Friendly takeover: offer
made directly to the firm’s management or its board of directors. Hostile takeover: offer bypassing
the firm’s management by approaching the firm’s shareholders directly with a tender offer (an offer to
purchase a certain number of shares at a specific price and on a specific date).
Strategic Acquisitions
Strategic acquisition: acquisition involving operating synergies (two firms are more profitable
combined than separated, due to reduced competition or cooperation in operations).
Financial Acquisitions
Financial acquisition: acquisition that includes no operating synergies, but motivated by tax gains or
undervaluation due to bad management (called disciplinary takeover). Financial acquisitions are
often structured as leveraged buyouts: taking a firm private by purchasing all its shares by issuing
debt.
Conglomerate Acquisitions
Type of Hostile or
Primary Motivation Trend
acquisition Friendly
During the 1990s, the number of hostile takeovers and LBOs decreased. This may be caused by
reduced incentives or because managers implemented various anti-takeover defenses.
Cross-Border Acquisitions
In the late 1990s, the number of cross-border mergers increased (multinational strategic
acquisitions).
Result 20.1 The main sources of takeover gains include: taxes, operating synergies, target
incentive problems, and financial synergies.
Tax Motivations
The Tax Act of 1982 allowed stepping up the basis of the acquired firm’s assets, increasing tax
depreciation shields. However, this was made undone by the Tax Reform Act of 1986. Takeovers
increase the interest tax shield: leverage increases because of better diversification or because both
firms are underleveraged and solve this by the merger. Before the Tax Reform Act of 1986 firms
could also benefit by using passed losses as a tax shield.
Result 20.2 Before the implementation of the Tax Reform Act of 1986, the U.S. Tax Code
encouraged corporations to acquire other corporations. Taxes currently play a much less important
role in motivating U.S. acquisitions. In some cases, however, mergers increase the combined
capacity of merged firms to utilize tax-favored debt.
Operating Synergies
Operating synergies are the result of improved productivity or cost reductions. Sources of synergies:
in a vertical merger (merger between supplier and customer), coordination and bargaining
problems are eliminated
in a horizontal merger (merger between competitors), competition is reduced and assets can be
shared
sharing a distribution network
transferring resources form one division to another (if demand fluctuates)
Disciplinary takeovers are usually hostile, often lead to the breakup of large diversified corporations
and result in job losses for top managers. In leveraged buyouts (LBOs), a raider (relatively thinly
capitalized individual) acquires a bigger enterprise using debt financing. Management buyout (MBO):
LBO by the top managers of the company. LBOs improve firm value by increasing management
incentives and a decreased margin of error. The increased firm value may also be caused by
employee layoffs or salary reductions that usually happen during LBOs. Firms acquiring other firms
for nonvalue-maximizing reasons have low market-to-book values and their share prices often react
negatively on takeover announcements.
Financial Synergies
Diversification reduces risk, which can result in operating synergies or financial synergies (a reduced
cost of capital). Reducing risk may lead to higher leverage and thus an increased tax shield. A
merger may also avoid the personal taxes on selling and reinvesting (by internally generated funds,
see 15.6).
Result 20.3 Conglomerates can provide funding for investment projects that independent (smaller)
firms would not have been able to fund using outside capital markets. To the extent that positive
NPV projects receive funding they would not have otherwise received, conglomerates create value.
Sometimes, takeover gains could also have been generated on alternative ways.
Mergers can destroy firm value if mangers transfer resources to subsidize money-losing lines of
business that would otherwise be shut down.
Because multiple activities are combined in one stock price, the stock price reveals less information
about one activity.
Result 20.5 Stock price reactions to takeover bids can be described as follows:
Target firm’s stock prices almost always react favorably to merger and tender offer bids
Bidder’s stock price goes up or down, depending on the circumstances
Combined market values of the shares of target and bidder go up, on average, around the time
of announced bids.
Result 20.3 The bidder’s stock price react more favorably, on average, when the bidder makes a
cash offer rather than an offer to exchange stock. This may reflect the relatively negative information
about its existing business signaled by the offer to exchange stock.
After the failure of a bid, share prices fall but stay still above their pre-bid level. This is the result of
signaling (the takeover premium shows the bidder has special information about the target) or
because most failed targets will eventually get taken over.
Share price reaction on diversifying takeovers is mostly period-related: the 1970s reacted
indifferently, while the 1960s en 1980s reacted negatively.
Although LBOs do not generate synergies, they are accompanied by large increases in stock prices.
The takeover premium is larger for high-cash flow/low-growth firms (due to large tax gains) and if
there is a competing bid.
During the 1980s, the cash flow increases by LBOs decreased, while their defaults on debt
increased.
Result 20.7 On average, cash flows of firms improve following leveraged buyouts. Three possible
explanations for these improvements are: (1) productivity gains, (2) initiation of LBOs by firms with
improving prospects, and (3) the incentive of leveraged firms to accelerate cash flows. All three
factors are expected to increase cash flows, but evidence suggests that a major part of the increase
is due to productivity gains.
Valuing Synergies
The current stock price comprises the firm’s current operating value and its expected takeover
premium multiplied by the takeover probability. So, part of the possible synergies are already
capitalized.
Step 2: Calibrate the valuation model (explain the difference stand-alone value between market
value)
Step 4: Value the acquisition (add the value of the synergies to the stand-alone value)
Three tax considerations affect the choice between offering cash, stock or a combination:
Capital gain tax liability by target’s shareholders results in preference for stock
Ability to step up/write up acquired asset value (before Tax Act of 1986)
Tax gains from leverage
Stock financing qualifies for pooling of interests accounting treatment: the items on the balance
sheets and income statement are simply added together. Paying cash leads to a purchase of assets,
which includes the takeover premium as amortizable goodwill. A purchase of assets may increase
the tax shield, but reduces the firm’s earnings. The FASB eliminated pooling of interest accounting,
just as the amortization of goodwill.
Stock offers may signal overvaluation of stock or uncertainty about the target’s value.
20.10 Bidding Strategies in Hostile Takeovers
Conditional tender offer: offer to purchase shares at a specific price if a specific number of shares is
tendered. The free-rider problem exists because shareholder that do not tender, expect to get a
higher price after the (partial) takeover, but a takeover is impossible if all shareholder behave like
this. This is also the case in an unconditional offer/any-or-all offer.
Result 20.8 Small shareholders will not tender their shares if they are offered less than the post-
takeover value of the shares. As a result, takeovers that could potentially lead to substantial value
improvement may fail.
A first solution to the free-rider problem is to buy stock on the open market (up to 5%) and to buy
from risk arbitrageurs (large shareholders). A second solution is to convince shareholders they won’t
profit from synergies by transferring wealth. A third solution is a two-tiered offer: after the initial
tender offer, the company offers end enforces a follow-up merger for remaining securities (worth less
than the tender offer, resulting in coercive two-tier offers). However, fair price amendments and laws
may require the second-tier price to be equal to the first-tier price.
Greenmail: buying back the bidder’s stock at substantial premium over its market price on
condition that the bidders suspend his bid.
Staggered board terms and supermajority rules: prevent takeover by increasing the amount of
shares needed to control the firm.
Poison pills: provide valuable rights to target shareholders who don’t tender, like the flipover
rights plan (target shareholders receive the right to purchase the acquiring firm’s stock at a
substantial discount in the event of a merger).
Lobbying for anti-takeover legislation: laws decreasing the influence or large investors.
Evidence on the reaction of stock prices to management defensive actions has been mixed.
Chapter 21 Risk Management and Corporate Strategy
Risk profile: the kinds of risk a firm is exposed to. Risk management: assessing and managing the
corporation’s exposure to various sources of risk through the use of financial derivatives, insurance,
and other activities. Hedging: taking offsetting positions. The increasing attention to risk
management is mostly due to increased volatility of interest rates and exchange rates. The
motivation for risk management comes from, among others, taxes, financial distress costs, executive
incentives.
Firms are exposed to undiversifiable factor risk (due to changes in macroeconomic factors) and to
diversifiable firm-specific risk. Firms can hedge their factor risk with derivative securities.
Also investors can hedge their factor risk by buying derivative instruments.
Result 21.1 If hedging choices do not affect cash flows from real assets, then, in the absence of
taxes and transaction costs, hedging decisions do not affect firm value.
Result 21.2 Hedging is unlikely to improve a firm’s value if it does no more than reduce the
variance of its future cash flows. To improve a firm’s value, hedging also must increase expected
cash flows.
A Simple Analogy
The asymmetry between gains and losses leads to risk-reducing choices, even by risk-neutral
investors.
Most benefits of hedging arise because the costs of receiving one dollar less exceeds the profits of
receiving one dollar more. The benefits associated with hedging are:
Result 21.3 Because of asymmetric treatment of gains and losses, firms may
reduce their expected tax liabilities by hedging.
Hedging reduces volatility, so decreasing the default probability and increasing debt capacity.
Result 21.4 Firms subject to high financial distress costs have greater incentives
to hedge.
Result 21.5 Firms that find it costly to delay or alter their investment plans and
that have limited access to outside financial markets will benefit from hedging.
This is because those firms depend strongly on their internally generated funds. Partial hedging
is preferred if investment opportunities or the ability of external financing depend on the risk
factor.
Hedging can reduce risks outside manager’s control, thereby improving the pay-for-performance.
Result 21.6 The gains from hedging are greater when it is more difficult to
evaluate and monitor management.
5. Hedging improves decision making
Hedging improves allocation decisions by creating certainty equivalents, but introduces the
fallacy of sunk costs (continuing manufacturing while selling the hedged commodity is more
profitable).
Result 21.7 Firms have an incentive to insure or hedge risks that insurance
companies and markets can better assess. Doing this improves decision making.
Firms will absorb internally those risks over which they have the comparative
advantage in evaluating.
Result 21.8 If a firm’s main motivation for hedging is to better assess the quality of management,
the firm will probably want to hedge its earnings or cash flows rather than its value. However, if the
firm is hedging to avoid the costs of financial distress, it should implement a hedging strategy that
takes into account both the variance of its value and the variance of its cash flows.
Result 21.9 Corporations should organize their hedging in a way that reflects why they are
hedging. Most hedging motivations suggest it should be carried out at the corporate level. However,
the improvements in management incentives are best achieved when the individual divisions are
responsible for hedging.
Result 21.10 Managers have private information only in exceptional cases. Given this, they almost
always should be hedging rather than speculating.
If hedging reduces volatility without increasing firm value, value is transferred from equity holders to
debt holders.
A managerial incentive to hedge are the transaction costs they bear if they would hedge their shares
in the firm personally. Managers have an incentive to speculate if they receive stock option
compensations.
Liability stream: stream of interest costs that a firm will be paying in the future. Liability management:
managing the firm’s exposure to interest rates, commodities an foreign exchange rates caused by
borrowing choices. Risk management: managing risk exposure with the aid of derivatives.
Result 21.11 A firm’s liability stream can be decomposed in two components: one that reflects
default-free interest rates, and one that reflects the firm’s credit rating. When a firm borrows at a
fixed rate, both components are fixed. When it rolls over short-term instruments, the liability streams
fluctuate with both kinds of risks.
Derivative instruments allow firms to separate these two sources of risk: labiality
streams sensitive to interest rates but not to credit ratings, and liabilities sensitive to credit ratings
but not to interest rates.
First, the choice of the firm’s liability streams is influenced by the need to match interest rate
exposure of assets and debt. Second, the expectations about the inflation component of interest
rates are important. Third, the exposure to changes in credit rating may lead to short-term and
interest rate swaps if the firm’s financial condition is unclear or the asset substitution problem may
occur.
Result 21.12 If changes in interest rates mainly reflect changes in the rate of inflation and if firm’s
unlevered cash flows generally increase with the inflation rate, the firm wants liabilities exposed to
interest rate risk. If interest rate changes are not due to inflation changes and the firm’s unlevered
cash flows are largely affected by the level of real interest rates, the firm wants to minimize the
exposure of liabilities to interest rate changes.
21.8 Foreign Exchange Risk Management
Multinationals have to manage their currency risks, because exchange rates influences performance.
1. Transaction risk: the immediate effect of an exchange rate on a cash flow. It is associated with
individual transactions denominated in foreign currencies.
2. Translation risk: the effect on the parent’s consolidated statements in the home currency. It
arises from translating the balance sheet and income statements in foreign currencies to the
parent’s currency.
3. Economic risk: the effect on firm’s fundamentals, like production location and area of distribution,
location of competitors and input prices. It is associated with losing competitive advantage due
to exchange rate movements.
Nominal exchange rate: the absolute price of a foreign currency. Real exchange rate: the relative
price of a foreign currency, which is the nominal rate corrected for inflation. The nominal exchange
rate, corrected with the CPI inflations of two countries gives the real exchange rates. If the
purchasing power is not influenced, hedging is unnecessary. However, firms should hedge real
exchange rate changes. Short-term exchange rate changes are generated by real changes,
indicating that short-term hedges are effective.
Result 21.13 Exchange rate movements can be decomposed into those caused by differences in
the inflation rates in both countries and those caused by changes in real exchange rates. In most
cases, the incentive is to hedge against real exchange rate changes.
The economic risk is often too hard to estimate, and therefore too difficult too hedge.
Result 21.14 When exchange rate changes can be generated by both real and nominal changes, it
may be impossible for firms to effectively hedge their long-term economic exposures.
21.9 Which Firms Hedge? The Empirical Evidence
larger firms are more likely to use derivatives than smaller firms (due to fixed costs)
firms with more growth opportunities are more likely to use derivatives (higher distress costs)
highly levered firms are more likely to use derivatives
in the gold mining industry, the managers personally exposed to risk choose to hedge more
in the oil and gas industry, relatively little is hedged, determined by leverage and the influence of
exchange-traded contracts.
9.1 Returns
Dollar Returns
The return of a stock consists of an income component (dividends) and a capital gain/loss (change
in market value of the share).
Percentage Returns
Four important types of financial instruments (in order of performance in the period 1926-2002):
The market return can be shown as a frequency distribution or we can calculate the mean/average.
The return on Treasury bills is a proxy for the risk-free return. The risk premium is the excess return
on the risky asset (difference between risky returns and return on T-bills), which is a compensation
for a higher variability in returns.
The risk of returns can be measured in different ways, like spread, variance and standard deviation.
Variance
The variance (σ2) and standard deviation (σ) measure the variability or dispersion: the probability the
return deviates a certain amount from the average return (R).
The probability of a return is reflected by the normal distribution, which is a symmetric, bell-shaped
curve.
Chapter 10 Return and Risk: The Capital Asset Pricing Model (CAPM)
(RWJ)
Expected return: the return an individual expects a stock to earn over the next period.
The expected return is the (weighted) average of different returns in different scenarios.
The variance is the average of the squared difference between the scenario return and the expected
return. The standard deviation is the square root of the variance.
Covariance (σAB) and correlation measure how two random variables are related. The covariance is
the average of the outcomes of multiplying the variance of one random variable (scenario return -
expected return) with the variance of the other random variable in the same scenario. The
correlation is the covariance divided the multiplication of the individual standard deviations of both
variables.
As long as ρ<1, the standard deviation of a portfolio of two securities is less than the weighted
average of the standard deviations of the individual securities.
If many stocks are chosen, the number of possible portfolios becomes large. But the expected return
and standard deviation of all these portfolios fall within a certain region which is also bounded by a
curve, forming the efficient set (Figure 10.6, 270).
The portfolio variance can be calculated with a matrix. The variance of the return on a portfolio with
many securities is more dependent on the covariance between the individual securities than on the
variances of the individual securities.
Variance of portfolio:
Total risk of individual security (var) = portfolio risk (cov) + unsystematic risk (var - cov)
(Important note: this is different from the sheets provided by Miss Penas!)
Except for investing, investors can also lend their money. The expected return is the risk-free rate,
while the standard deviation equals zero.
The optimal portfolio is a portfolio on the Capital Market Line (CML). The CML represents all
portfolios which consist of risk-free lending and the optimal stock portfolio. The CML is a straight line,
starting at the risk-free rate tangent to the efficient frontier. Beyond the point where it touches the
efficient frontier (100% of the portfolio invested in stock), the investor borrows at the risk-free rate
while investing in stock. Look at figure 10.9 (278).
The separation principle: the two separate steps of investment decision (first, calculate the efficient
frontier, second, determine the CML).
Homogeneous expectations: all investors have the same expectations. In a world with homogeneous
expectations, all investors would hold the portfolio of risky assets represented by the point where the
CML touches the efficient frontier. This portfolio is called the market portfolio.
The best measure for risk of a security is its beta. The beta is the slope of the characteristic line (line
representing the relation between market return and security return).
A rational, risk-averse investor views the variance of his portfolio’s return as the proper measure of
risk. If he only holds one security, the variance of that security’s return is the proper measure of risk.
If an individual holds a diversified portfolio, he is only interested in the contribution of an individual
security to the portfolio variance (the beta).
RM = RF + Risk premium
The capital-asset-pricing model is represented by the Security Market Line (SML; the linear
relationship between the security’s beta and its return).
- Proxy contest
- Acquisition of stock
- Acquisitions of assets
Takeover: general, imprecise term referring to the transfer of control of a firm between shareholders.
Going-private transactions: purchase of all equity shares of a public firm by a small group of
investors.
Proxy contests: attempt by a group of shareholders to gain controlling seats by voting new directors.
Acquisition: acquiring a target firm and electing a new board that has control of the operating
activities.
Bidder: a firm/group offering cash or securities to obtain stocks or assets of another company.
1. Merger or consolidation
Merger: the absorption of one firm by another by acquiring all assets and liabilities.
Consolidation: merger where a newly created firm acquires all assets and liabilities and the
acquired and acquiring companies cease to exist.
In both forms, the result is a combination of assets and liabilities of both companies.
2. Acquisition of stock: purchasing the firm’s voting stock in exchange for cash, shares or other
securities. This can be done by a private offer or tender offer (public offer to buy shares).
Important issues:
3. Acquisition of assets: acquiring another firm by buying all its assets. Requires shareholders’
approval, but no minority shareholders. Legally transferring process can be costly.
Classification of acquisitions:
Acquisitions influence accounting of the stockholders’ books according to the purchase method.
The purchase method requires that assets of the acquired firm are reported at fair market value on
the books of the acquiring firm. Goodwill is the excess of the purchase price over the fair market
value of the firm (purchase price - NPV of acquired firm). After-acquisitions balance consists of:
acquiring firm assets at book value, acquired firms assets at market value, and goodwill.
Synergy: the difference between the value of combined firm and the value of both separated firms
together, equal to the NPV of changes in cash flows after acquisition.
Marketing gains: improved marketing by more effective advertising, stronger distribution network,
and a more balanced product mix
Strategic benefits: take advantage by combining knowledge/technology
Market or monopoly power: reduce competition
Net operating losses: taking advantage of tax losses an unprofitable firm cannot take advantage
of (implied costs: carryover advantages; may be illegal)
Unused debt capacity: diversification lowers cost of financial distress changing the optimal debt-
equity ratio to gain a higher tax-advantage
Surplus funds: dividends are taxed an repurchasing shares is illegal, but merging is tax-free
The value of the firm after an acquisition is the sum of the market value of the acquiring firm, the
market value of the acquired firm and the present value of increased tax flows (tax gains, operating
efficiencies, strategic fit). General rules:
After acquisition, there is a coinsurance effect: reduction in variability of firm values reduces the risk.
When two all-equity firms merge, stock price does not change.
When one firm has debt, the coinsurance effect will favour bondholders. Due to a risk reduction,
bond value increases. The amount bondholders gain is the same amount as the stockholders are
hurt (assuming no synergy effects exist). This can be prevented by retiring all debt before the
acquisition of issuing new debt after the acquisition.
1. Earnings growth. Companies try to fool shareholders by buying a firm without acquisition
synergies, but only increased earnings after the acquisition. The new market value is just the
sum of both firms, the price-earnings ratio the weighted average.
2. Diversification. Systematic risk can’t be reduced, but systematic risk can. However, this should
only be done when: (1) risk reduction at lower rates than stock differentiation (unlikely) and (2)
the risk is reduced so debt capacity can be increased.
The NPV of an acquisition depends on the way the acquisition is paid for:
Cash: NPV of merger = Market value of combined firm - cash paid = Synergy - Premium
Synergy: the NPV of all increased cash flows of the combined firm
Stock: If the ratio for stock-for-stock transactions is based on pre-merger market values, the
shareholders of the acquired firm will benefit more because they receive the premium, but
also a part of the synergy. Therefore, the number of shares stockholders should get, is
calculated by two equations:
Three issues:
overvaluation: when stocks are overvalued, acquiring with stock is less costly
taxes: acquisition by cash is taxable, acquisition by stock is cash free
sharing gains: in acquisition by stock, shareholders of the acquired firm will share in the benefits
Gains from going private: increase of debt causes tax deduction and managers’ incentive
increase after becoming owners
Other devices:
o Golden parachutes: high compensation for the management
o Crown jewels: selling major assets (crown jewels) for scorched earth strategy
o Poison pill: distribute the right to buy shares at bargain price to shareholders
o White knight: arrangement to be acquired by another, more friendly company
o Lockup: option given to friendly company to purchase stock or assets
o Shark repellent: any tactic that makes the firm less attractive
o Bear hug: unfriendly takeover too attractive to resist
Shareholders of the target firm achieve substantial gains (tender offer > merger)
Shareholders of acquiring firm earn little to nothing, probably causes by: not achieving merger
gains, bigger size of acquiring company, selfish management
Shareholders of unsuccessful mergers receive a negative return.
In general, shareholders of acquired firms benefit and shareholders of the acquiring firm loose.
However, after-merger productivity seems to be increased.
Keiretsu: network of business combinations with reciprocal shareholding and trading agreements.