1

MSC Semester 2, 2003: Company Finance

Richard Fairchild: http://staff.bath.ac.uk/mnsrf.

Room: WH9.21 Email: mnsrf@bath.ac.uk

1. Topics in Investment Appraisal.

2. Risk and Return/ Portfolio Analysis.

3. Cost of Capital, Capital Structure, Firm Value.

4. Optimal Capital Structure - Agency Costs, Signalling.

5. Dividend Policy.

6. Options/Risk Management.

7. Convertible Debt.

8. Mergers and Takeovers.

2

Connections throughout the course.

Investment Appraisal: Net Present Value with discount rate (cost of capital) given. Positive NPV increases value of the firm.

Cost of Capital (discount rate): How do companies derive the cost of capital? – CAPM, DVM.

Capital Structure and effect on Firm Value and WACC.

3

Income Statement.

Revenue

-Variable Costs

-Fixed costs

-EBIT

-rD

EBT

-tax

Net Income

-Dividends

Retained earnings

Finance Topics.

Revenue Risk.

Operating Leverage.

Business Risk.

Financial Gearing.

Shareholder Risk and Return

Dividend Policy.

4

Balance Sheet.

Liabilities

Share Capital

+ Retained Earnings

Equity

Debt (eg loans etc)

Total Liabilities

Assets

Fixed Assets

Current Assets

Total Assets

Balance Sheet is a snapshot.

Total Assets = Total Liabilities.

Book Value of Equity.

Topic: Capital Structure (market values).

5

SECTION 1: Investment Appraisal.

1. Debate over Correct Method

- Accounting Rate of Return.

- Payback.

- NPV.

- IRR.

- POSITIVE NPV Increases Shareholder Wealth.

2. Correct Method - NPV!

-Time Value of Money

- Discounts all future cashflows

6

Calculation of NPV.

.....)1()1(1 3

32

21

r

X

r

X

r

XINPV

Perpetuities:

r

XINPV

Value of the Firm = present value of future cashflows.

.....)1()1(1 3

32

21

r

X

r

X

r

XPVV

r

XPVV or

Positive NPV increases firm value.

7

Example.

Consider the following new project:

-initial capital investment of £15m.

-it will generate sales for 5 years.

- Variable Costs equal 70% of sales value.

- fixed cost of project £200m PA.

- A feasibility study, cost £5000, has already been carried out.

Discount Rate equals 12%.

Should we take the project?

8

$000 2000 2001 2002 2003 2004 2005 SALES 14000 16000 18000 20000 22000 90000

VARIABLE COSTS -9800 -11200 -12600 -14000 -15400 -63000

OPERATING EXPENSES -200 -200 -200 -200 -200 -1000

EQUIPMENT COSTS -15000 -15000

CASHFLOWS -15000 4000 4600 5200 5800 6400 11000

DF @ 12% 1.00 0.893 0.797 0.712 0.636 0.567

NPV -15000 3571 3667 3701 3686 3632 3257

19.75 1.00 0.84 0.70 0.58 0.49 0.41

IRR = 19.75% -15000 3340 3208 3028 2820 2599 -4

DO WE INVEST IN THIS NEW PROJECT?

NPV > 0.

COST OF CAPITAL (12%) < IRR (19.75%).

9

Note that if the NPV is positive, then the IRR exceeds the Cost of Capital.

NPV £m

Discount Rate %

12 %

3.3m

19.7%0

10

YEAR A B C D DF: 10%

0 -1000 -1000 -1000 -1000 11 100 0 100 200 0.9092 900 0 200 300 0.8263 100 300 300 500 0.7514 -100 700 400 500 0.6835 -400 1300 1250 600 0.621

PAYBACK METHOD:

PROJECT A: 2 YEARS SELECT PROJECT APROJECT B: 4 YEARSPROJECT C: 4 YEARSPROJECT D: 3 YEARS

NPV:

PROJECT A: -407PROJECT B: 511PROJECT C: 531 SELECT PROJECT CPROJECT D: 519

IRR

PROJECT A: -200%PROJECT B: 20.9%PROJECT C: 22.8%PROJECT D: 25.4% SELECT PROJECT D

Conflict Between Appraisal Techniques.

11

NPV

Discount Rate10% 22.8%

PROJ C

531

PROJ D

519

25.4%

COMPARING NPV AND IRR - 1

Select Project with higher NPV: Project C.

12

NPV

Discount Rate

COMPARING NPV AND IRR -2

Impossible to find IRR!!! NPV exists!

13

COMPARING NPV AND IRR –3

Discount Rate: 10%

Project A : Date 0 Investment -£1000.

Date 1 Cashflow £1500.

NPV = £364.

IRR = 50%

Project B:- Date 0 Investment -£10

Date 1 Cashflow £18.

NPV = £6.36

IRR = 80%.

Which Project do we take?

14

Mutually Exclusive Versus Independent Projects.

-Mutually exclusive – we can only select one project- we choose the one with the highest NPV (project 1).

-Independent Projects – select all positive NPV projects (all projects).

Capital Rationing.

Project PV of Inflows

Current

Outflows

PVI NPV

1 230,000 200,000 1.15 30,000

2 140,000 125,000 1.12 15,000

3 195,000 175,000 1.11 20,000

4 162,000 150,000 1.08 12,000

15

Capital Rationing And Independent Projects.

The firm is limited to a capital constraint of £300,000.

Consider combinations of projects that maximise weighted average PVI.

Eg: Projects 2 and 3:

.117.111.1000,300

000,17512.1

000,300

000,125PVI

Project 1:

10.10.1300000

10000015.1

300000

200000PVI

Selecting Project 2 and 3 is superior to project 1.

16

Treatment of depreciation in NPV analysis.

-We only use cashflows in investment appraisal.

-Depreciation is not a cashflow.

-However, depreciation is allowable against tax (see income statement), which affects cashflow.

For cashflow, add depreciation back:-

.)1( depTNOINCF

17

Treatment of depreciation.

$000 2000 2001 2002 2003 2004 2005 SALES 14000 16000 18000 20000 22000 90000

VARIABLE COSTS -9800 -11200 -12600 -14000 -15400 -63000

OPERATING EXPENSES -200 -200 -200 -200 -200 -1000

EQUIPMENT COSTS -15000 -15000DEPRECIATION -3000 -3000 -3000 -3000 -3000NOI -15000 1000 1600 2200 2800 3400 11000NOI AFTER TAX 800 1280 1760 2240 2720 8800ADD BACK DEPN (= NCF) 3800 4280 4760 5240 5720 23800

DF @ 12% 1.00 0.893 0.797 0.712 0.636 0.567 -15000 3393 3412 3388 3330 3246 1769

NPV -15000 3266 3162 3022 2859 2683 -8 16.35 1.00 0.86 0.74 0.63 0.55 0.47

18

Capital Budgeting and Inflation.

01 )1(

Ik

NCFPVN

N

ttt

K is the nominal cost of capital. We require real cost of capital, where

).1()1)(1( kInfr

Either add inflation to the cashflow estimates, or remove inflation from the nominal cost of capital.

19

NPV and Competitive Bidding.

Positive NPV => immediate increase in share price.

Negative NPV => decrease in share price.

Competitive bid for a supply contract, where lowest price wins (eg Space Structures exercise).

Find Lowest bid price without NPV going negative.

Find bid price such that NPV is zero.

Eg: A company is bidding for a contract to supply Y units P.A. for 3 years.

Optimal bid price P?

20

The optimal bid price solves;

0)1()1(1 3

3221

r

CPY

r

CPY

r

CPYINPV

Or: if supply forever (perpetuities)

r

CPYINPV

Simple to rearrange these equations to find P!

21

Decision Trees and Sensitivity Analysis.

Example: From RWJ.

New Project: Test and Development Phase: Investment $100m.

0.75 chance of success.

If successful, Company can invest in full scale production, Investment $1500m.

Production will occur over next 5 years with the following cashflows.

22

$000 Year 1 Year 2

Revenues 6000Variable Costs -3000Fixed Costs -1791Depreciation -300

Pretax Profit 909Tax (34%) -309

Net Profit 600Cashflow 900

Initial Investment -1500

Date 1 NPV = -1500 +

5

1 )15.1(

900

tt

= 1517

Production Stage: Base Case

23

Decision Tree.

Test

Do Not Test

Success

Failure

Invest

Do not Invest

Do not Invest

Invest

NPV = 1517

NPV = 0

NPV = -3611

Date 0: -$100 Date 1: -1500

Solve backwards: If the tests are successful, SEC should invest, since 1517 > 0.

If tests are unsuccessful, SEC should not invest, since 0 > -3611.

P=0.75

P=0.25

24

Now move back to Stage 1.

Invest $100m now to get 75% chance of $1517m one year later?

Expected Payoff = 0.75 *1517 +0.25 *0 = 1138.

NPV of testing at date 0 = -100 + 15.1

1138 = $890

Therefore, the firm should test the project.

Sensitivity Analysis (What-if analysis or Bop analysis)

Examines sensitivity of NPV to changes in underlying assumptions (on revenue, costs and cashflows).

25

Sensitivity Analysis.

- NPV Calculation for all 3 possibilities of a single variable + expected forecast for all other variables.

NPV Expected Pessimistic or Best Optimistic

Market Size -1802 1517 8154Market Share -696 1517 5942Price 853 1517 2844Variable Cost 189 1517 2844Fixed Cost 1295 1517 1628Investment 1208 1517 1903

Limitation in just changing one variable at a time.

Scenario Analysis- Change several variables together.

Break - even analysis examines variability in forecasts.

It determines the number of sales required to break even.

26

Break-even Analysis.

Accounting Profit.

Breakeven Point = 2091 Engines.

NPV.

Breakeven Point = 2315 Engines.

Unit Sales NPV

0 -51201000 -29083000 1517

10000 17004

Unit Sales NetProfit

0 -13801000 -7203000 600

10000 5220

27

The Investment Appraisal Debate.

Richard Pike:

Year of Survey

1975 1980 1986 1992

Technique % % % %

Payback 73 81 92 94

ARR 51 49 56 50

IRR 44 57 75 81

NPV 32 39 68 74

Sample size: 100 Large UK based Firms.

28

Combination of Techniques: Pike 1992:

Year 1975 1980 1986 1992

No Methods

2 0 0 0

Single Method

31 (0) 24 (1) 8 (0) 4 (= PB)

2 34 (6) 40 (11) 29 (9) 28 (11)

3 22 (15) 24 (14) 29 (24) 32 (27)

4 11 12 34 36

Total 100 (32) 100 (38) 100 (67) 100 (74)

( ) = NPV

29

Some Reasons for usage of wrong techniques.

-Managers prefer % figures => IRR, ARR

-Managers don’t understand NPV/ Complicated Calculations.

-Payback simple to calculate.

-Short-term compensation schemes => Payback (Levy 200 –203, Pike 1985 pg 49).

Increase in Usage of correct DCF techniques:

Computers.

Management Education.

30

Berkovitch and Israel: Why the NPV Criterion does not Maximise NPV.

-So far, NPV has been best technique, and managers use other techniques through ignorance.

-In contrast, Berkovitch and Israel argue that NPV might sometimes be inefficient.

-Model –Divisional Mgt identify investment opportunities.

Submit capital budget requests to top mgt (HQ).

-divisional mgr is an empire builder- submits bigger project with lower NPV – hides smaller project with higher NPV.

-IRR or PI performs better.

31

SECTION 2: Cost Of Capital.

The cost of capital = investors’ required return on their investment in a company.

It provides the appropriate discount rate in NPV.

Investors are risk averse.

Future share prices (and returns) are risky (volatile).

The higher the risk, the higher the required return.

p

t

r

t

100*1

1

t

ttt P

PPr

A

B

32

Risk and Return.

An investor’s actual return is the percentage change in price:

100*1

t

tt

P

PPR

Risk = Variability or Volatility of Returns, Var (R).

We assume that Returns follow a Normal Distribution.

E(R)

Var(R).

./)....)( 21 TRRRAverageRE T

33

What do we mean by Risk?

The risk reflects the distribution (spread) of expected future returns.

Investors are assumed to be risk-averse (don’t like risk).

The higher the spread (risk), the higher the required return => current price adjusts to reflect this.

Risk.

A

B

B is riskier than A.

A

B

Time

Returns

34

Risk Aversion.

Investors prefer more certain returns to less certain returns.

Wealth

U

150100 200

Risk Averse Investor prefers £150 for sure than a 50/50 gamble giving £100 or £200.

35

Portfolio Analysis.

Two Assets: Investor has proportion a of Asset X and (1-a) of Asset Y.

).()1()(.)( YXp REaREaRE

).,(.2)(.)1()(.)( 22 yxCovabYVaraXVaraRVar p

Combining the two assets in differing proportions.

E(R)

36

Portfolio of Many assets + Risk Free Asset.

E(R)

*

*

* * *

*fr

M.Efficiency Frontier.

All rational investors have the same market portfolio M of risky assets, and combine it with the risk free asset.

A portfolio like X is inefficient, because diversification can give higher expected return for the same risk, or the same expected return for lower risk.

X

37

The Effect of Diversification on Portfolio Variance.

P

Number of Assets.

An asset’s risk = Undiversifiable Risk + Diversifiable Risk

= Market Risk + Specific Risk.

Market portfolio consists of Undiversifiable or Market Risk only.

38

Summary of Risk and Return:

Investors are assumed to be risk averse.

They combine assets to diversify (reduce) risk.

The more assets, the lower the specific risk.

The market portfolio diversifies away all specific risk, and contains all assets in the right proportions.

Implications for Investors.

Current share prices (which affect expected returns) are such that the market only rewards investors for holding market risk, not specific risk.

*****Implications for Individual Firms. ***********

Cost of Capital (Investor’s required return) should only reflect Market Risk – (Beta – CAPM).

39

Cost of Equity.

Dividend Valuation Model.

.

.)1(

1

10

gK

DivV

gV

Divg

V

gDivK

ee

eee

This assumes that all net cashflows are paid out as dividends.

Interchangeability- if we know the dividends and the market value, we can calculate the cost of equity.

If we know the cost of equity and the dividends, we can calculate the market value.

40

Cost of Equity (continued)

CAPM

.])([)( fmfi rrErrE

quantity of risk.

)(rE

fr

1

)( mrE

Security Market Line.

41

Estimating Cost of Equity Using Regression Analysis.

We regress the firm’s past share price returns against the market.

.

.

i

imii

b

rbar

ir

mrSee the regression exercise on my home page.

42

Weighted Average Cost of Capital (WACC).

When we have estimated Cost of Debt, and Cost of Equity-

if we have market values of debt and equity, we can calculate WACC – discount rate for new investments.

...

de

ddee

VV

KVKVWACC

See Mobil Energy Exercise.

43

Link to Section 3: Link between Value of the firm and NPV.

Positive NPV project immediately increases current equity value (share price immediately goes up!)

oo EBV Pre-project announcement

New project: .IVNPV n INew capital (all equity)

I

Value of Debt oBIVE n 0

New Firm Value

Original equity holders

New equity

nVV

44

Example:

oo EBV =500+500=1000.

I IVNPV n 60 -20 = 40.

oB = 500.

IVE n 0 = 500+40 = 540

I = 20

nVV =1000+60=1060.

200

Value of Debt

Original Equity

New Equity

Total Firm Value

45

Positive NPV: Effect on share price.

Assume all equity.

Market No of Price per Market No of Price per£K Value Shares Share Value Shares Share

Current 1000 1000 1 1040 1000 1.04

New Project 20 19 1.04

Project Income 60 1060 1019 1.04

Required Investment 20

NPV 40

46

SECTION 3: Value of the Firm and Capital Structure.

Introduction:-

Value of the Firm = Value of Debt + Value of Equity = discounted value of future cashflows available to the providers of capital.

(where values refer to market values).

Capital Structure is the amount of debt and equity: It is the way a firm finances its investments.

Unlevered firm = all-equity.

Levered firm = Debt plus equity.

Miller-Modigliani said that it does not matter how you split the cake between debt and equity, the value of the firm is unchanged (Irrelevance Theorem).

47

Value of the Firm = discounted value of future cashflows available to the providers of capital.

-Assume Incomes are perpetuities.

Miller- Modigliani Theorem:

..)1(

.

)1(

d

dDEUL

EC

U

K

Bk

eK

NIVV

WACC

TNCFBTVV

VTNCF

V

Irrelevance Theorem: Without Tax, Firm Value is independent of the Capital Structure.

Note thatV

VTKVKWACC ddee ).1(.

48

K

D/E

K

D/E

V

D/E D/E

V

49

Which Cashflows do we use?

Annual Income statement:

Revenues 1000

Less Variable Costs 200

Less Fixed Costs 200

EBIT (=NCF) 600

Less Debt Interest (2000 @ 5%) 100 for debtholders

EBT 500

Less Tax (20%) 100

Net Income (NI) 400 for equityholders

50

Calculating Levered Firm Value in our Numerical Example (see Income Statement).

Let Cost of levered Equity:

Market Value of Debt = 2000. Cost of risk free Debt = 5%.

a)

%.10eK

.600020004000200010.0

400LV

b) Now, %.86000

2000*)2.01(*54000*10

WACC

.600008.0

)2.01(600

LV=>

See Henderson Exercise.

51

MM main assumptions:

- Symmetric information.

-Managers unselfish- maximise shareholders wealth.

-Risk Free Debt.

MM assumed that investment and financing decisions were separate. Firm first chooses its investment projects (NPV rule), then decides on its capital structure.

Pie Model of the Firm:

D

E

E

52

MM irrelevance theorem- firm can use any mix of debt and equity – this is unsatisfactory as a policy tool.

Searching for the Optimal Capital Structure.

-Tax benefits of debt.

-Asymmetric information- Signalling.

-Agency Costs (selfish managers).

-Debt Capacity and Risky Debt.

Optimal Capital Structure maximises firm value.

53

Combining Tax Relief and Debt Capacity (Traditional View).

D/E D/E

V

K

54

Section 4: Optimal Capital Structure, Agency Costs, and Signalling.

Agency costs - manager’s self interested actions. Signalling - related to managerial type.

Debt and Equity can affect Firm Value because:

- Debt increases managers’ share of equity.

-Debt has threat of bankruptcy if manager shirks.

- Debt can reduce free cashflow.

But- Debt - excessive risk taking.

55

AGENCY COST MODELS.

Jensen and Meckling (1976).

- self-interested manager - monetary rewards V private benefits.

- issues debt and equity.

Issuing equity => lower share of firm’s profits for manager => he takes more perks => firm value

Issuing debt => he owns more equity => he takes less perks => firm value

56

Jensen and Meckling (1976)

B

V

V*

V1

B1

A

If manager owns all of the equity, equilibrium point A.

Slope = -1

57

B

V

Jensen and Meckling (1976)

V*

V1

B1

AB

If manager owns all of the equity, equilibrium point A.

If manager owns half of the equity, he will got to point B if he can.

Slope = -1

Slope = -1/2

58

B

V

Jensen and Meckling (1976)

V*

V1

B1

AB

C

If manager owns all of the equity, equilibrium point A.

If manager owns half of the equity, he will got to point B if he can.

Final equilibrium, point C: value V2, and private benefits B1.

V2

B2

Slope = -1

Slope = -1/2

59

Jensen and Meckling - Numerical Example.PROJECT PROJECTA B

EXPECTED INCOME 500 1000

MANAGER'S SHARE:100% 500 1000

VALUE OF PRIVATE 800 500BENEFITS

TOTAL WEALTH 1300 1500

MANAGER'S SHARE:50% 250 500

VALUE OF PRIVATE 800 500BENEFITS

TOTAL WEALTH 1050 1000

Manager issues 100% Debt.

Chooses Project B.

Manager issues some Debt and Equity.

Chooses Project A.

Optimal Solution: Issue Debt?

60

Issuing debt increases the manager’s fractional ownership => Firm value rises.

-But:

Debt and risk-shifting.

Project 1 Project 2 Probability

State 1 100 0 0.5

State 2 100 160 0.5

100 80

Values: Debt 50 25

Equity 50 65

61

OPTIMAL CAPITAL STRUCTURE.

Trade-off: Increasing equity => excess perks.

Increasing debt => potential risk shifting.

Optimal Capital Structure => max firm value.

D/E

V

D/E*

V*

62

Other Agency Cost Reasons for Optimal Capital structure.

Debt - bankruptcy threat - manager increases effort level. (eg Hart, Dewatripont and Tirole).

Debt reduces free cashflow problem (eg Jensen 1986).

63

Agency Cost Models – continued.

Effort Level, Debt and bankruptcy (simple example).

Debtholders are hard- if not paid, firm becomes bankrupt, manager loses job- manager does not like this.

Equity holders are soft.

Effort Level

High Low Required

Funds

Income 500 100 200

What is Optimal Capital Structure (Value Maximising)?

64

Firm needs to raise 200, using debt and equity.

Manager only cares about keeping his job. He has a fixed income, not affected by firm value.

a) If debt < 100, low effort. V = 100. Manager keeps job.

b) If debt > 100: low effort, V < D => bankruptcy. Manager loses job.

So, high effort level => V = 500 > D. No bankruptcy => Manager keeps job.

High level of debt => high firm value.

However: trade-off: may be costs of having high debt levels.

65

Free Cashflow Problem (Jensen 1986).

-Managers have (negative NPV) pet projects.

-Empire Building.

=> Firm Value reducing.

Free Cashflow- Cashflow in excess of that required to fund all NPV projects.

Jensen- benefit of debt in reducing free cashflow.

66

Jensen’s evidence from the oil industry.

After 1973, oil industry generated large free cashflows.

Management wasted money on unnecessary R and D.

also started diversification programs outside the industry.

Evidence- McConnell and Muscerella (1986) – increases in R and D caused decreases in stock price.

Retrenchment- cancellation or delay of ongoing projects.

Empire building Management resists retrenchment.

Takeovers or threat => increase in debt => reduction in free cashflow => increased share price.

67

Jensen predicts:

young firms with lots of good (positive NPV) investment opportunities should have low debt, high free cashflow.

Old stagnant firms with only negative NPV projects should have high debt levels, low free cashflow.

Stultz (1990)- optimal level of debt => enough free cashflow for good projects, but not too much free cashflow for bad projects.

68

Income Rights and Control Rights.

Some researchers (Hart (1982) and (2001), Dewatripont and Tirole (1985)) recognised that securities allocate income rights and control rights.

Debtholders have a fixed first claim on the firm’s income, and have liquidation rights.

Equityholders are residual claimants, and have voting rights.

Class discussion paper: Hart (2001)- What is the optimal allocation of control and income rights between a single investor and a manager?

How effective are control rights when there are different types of investors?

Why do we observe different types of outside investors- what is the optimal contract?

69 

  Conflict Benefits of Debt Costs of Debt

Breaking MM   Tax Relief Fin’l Distress/ Debt Capacity

       

Agency Models      

JM (1976) Managerial Perks

Increase Mgr’s Ownership

Risk Shifting

Jensen (1986) Empire Building Reduce Freecash Unspecified.

Stultz Empire Building Reduce Freecash Underinvestment.

       

Dewatripont and Tirole, Hart.

Low Effort level Bankruptcy threat =>increased effort

DT- Inefficient liquidations.

70

Signalling Models of Capital Structure

Assymetric info: Akerlof’s (1970) Lemons Market.

Akerlof showed that, under assymetric info, only bad things may be traded.

His model- two car dealers: one good, one bad.

Market does not know which is which: 50/50 probability.

Good car (peach) is worth £2000. Bad car (lemon) is worth £1000.

Buyers only prepared to pay average price £1500.

But: Good seller not prepared to sell. Only bad car remains.

Price falls to £1000.

Myers-Majuf (1984) – “securities may be lemons too.”

71

Asymmetric information and Signalling Models.

- managers have inside info, capital structure has signalling properties.

Ross (1977)

-manager’s compensation at the end of the period is

DVCVVrM

DVVVrM

11100

11100

if )1(

if )1(

D* = debt level where bad firm goes bankrupt.

Result: Good firm D > D*, Bad Firm D < D*.

Debt level D signals to investors whether the firm is good or bad.

72

Myers-Majluf (1984).

-managers know the true future cashflow.

They act in the interest of initial shareholders.P = 0.5 Do

Nothing:

Good Bad

IssueEquity

Good BadAssetsin Place

250 130 350 230

NPV ofnewproject

0 0 20 10

Value ofFirm

250 130 370 240

Expected Value 190 305

New investors 0 100

Old Investors 190 205

73

Consider old shareholders wealth:

Good News + Do nothing = 250.

Good News + Issue Equity =

Bad News and do nothing = 130.

.69.248)370(305

205

Bad News and Issue equity = .31.161)240(305

205

74

Donothing

Issueandinvest

GoodNews

250 * 248.69

BadNews

130 161.31*

Old Shareholders’ payoffs EquilibriumDonothing

Issueandinvest

GoodNews

250 * 248.69

BadNews

130 140 *

Issuing equity signals that the bad state will occur.

The market knows this - firm value falls.

Pecking Order Theory for Capital Structure => firms prefer to raise funds in this order:

Retained Earnings/ Debt/ Equity.

75

Evidence on Capital structure and firm value.

Debt Issued - Value Increases.

Equity Issued- Value falls.

However, difficult to analyse, as these capital structure changes may be accompanied by new investment.

More promising - Exchange offers or swaps.

Class discussion paper: Masulis (1980)- Highly significant Announcement effects:

+7.6% for leverage increasing exchange offers.

-5.4% for leverage decreasing exchange offers.

76

Section 5: Dividend Policy – Overview.

1. Miller Modigliani Irrelevance Theorem – Dividend Policy does not affect firm value, since Shareholders are only interested in Cashflow available.

2. Signalling – Dividend policy may affect firm value by signalling good or bad firm.

3. Gordon Growth Model – If growth comes from re-investing, then dividend policy may affect firm value.

4. Lintner Model – If managers care about signalling, then they may smooth the pattern of dividends over time.

77

Section 5: Dividend Policy.

Assume All equity firm.

Value of Firm = Value of Equity = discounted value of future cashflows available to equity holders = discounted value of dividends (if all available cashflow is paid out).

0

0

0

0

)1(

)1(

ttt

tt

INCFV

DivV

t

t

If everything not reinvested is paid out as dividends, then

78

Miller Modigliani’s Dividend Irrelevance.

NSDivINCF

DivINSNCF

tttt

tttt

Source of Funds = Application of Funds

MM used a source and application of funds argument to show thatDividend Policy is irrelevant:

11

0)1()1( tttt

tttt INCFNSDiv

V

79

1

0)1(tttt INCF

V

-Dividends do not appear in the equation.

-If the firm pays out too much dividend, it issues new equity to be able to reinvest. If it pays out too little dividend, it can use the balance to repurchase shares.

-Hence, dividend policy irrelevant.

-Key is the availability of finance in the capital market.

80

Example of Dividend Irrelevance using Source and Application of Funds.

Firm invests in project giving it NCF = 100 every year, and it needs to re-invest, I =50 every year.

Cashflow available to shareholders = NCF – I = 50.

Now, NCF – I = Div – NS = 50.

If firm pays dividend of 50, NS = 0 (ie it pays out exactly the cashflow available – no new shares bought or sold).

If firm pays dividend of 80, NS = -30 (ie it sells new shares of 30 to cover dividend).

If firm pays dividend of 20, NS = 30 (ie it uses cashflow not paid out as dividend to buy new shares).

In each case, Div – NS = 50.

81

Gordon Growth Model.

Where does growth come from?- retaining cashflow to re-invest.

.)1(11

0g

kNCFg

DivV

Constant fraction, K, of earnings retained for reinvestment.

Rest paid out as dividend.

Average rate of return on equity = r.

Growth rate in cashflows (and dividends) is g = Kr.

82

Example of Gordon Growth Model.£K 19x5 19x6 19x7 19x8 19x9 Average Profits After Tax (NCF) 2500 2760 2635 2900 3100Retained Profit (NCF.K) 1550 1775 1600 1800 1900

Dividend (NCF(1-K)) 950 985 1035 1100 1200

Share Capital + retentionsB/F 30000 31550 33325 34925 36725C/F (= BF + Retained Profit) 31550 33325 34925 36725 38625

Retention Rate K 0.62 0.64 0.61 0.62 0.61 0.62r on opening capital 0.083 0.087 0.079 0.083 0.084 0.083

g = Kr = 0.05.

How do we use this past data for valuation?

83

Gordon Growth Model (Infinite Constant Growth Model).

Let

.1800005.12.0

1260

.1260)05.1(1200

.1200)1(

).1)(1()1()1(

0

1

00

0011

V

Div

KNCFDiv

gKNCFgDivKNCFDiv

%12

84

Finite Supernormal Growth.

-Rate of return on Investment > market required return for T years.

-After that, Rate of Return on Investment = Market required return.

)1(

)(.. 1

10

rTNCFK

NCFV

If T = 0, V = Value of assets in place (re-investment at zero NPV).

Same if r = .

85

Examples of Finite Supernormal Growth.

%.10

.1001

NCF

T = 10 years. K = 0.1.

A. Rate of return, r = 12% for 10 years,then 10% thereafter.

1018)1.01(1.0

)1.012.0(10).100.(1.0

1.0

1000

V

B. Rate of return, r = 5% for 10 years,then 10% thereafter.

955)1.01(1.0

)1.005.0(10).100.(1.0

1.0

1000

V

86

Are Dividends Irrelevant?

- Evidence: higher dividends => higher value.

- Dividend irrelevance : freely available capital for reinvestment. - If too much dividend, firm issued new shares.

- If capital not freely available, dividend policy may matter.

Dividend Signalling - Miller and Rock (1985).

NCF + NS = I + DIV: Source = Uses.

DIV - NS = NCF - I.

Right hand side = retained earnings. Left hand side - higher dividends can be covered by new shares.

87

Div - NS - E (Div - NS) = NCF - I - E (NCF - I)

= NCF - E ( NCF).

Unexpected dividend increase - favourable signal of NCF.

Prob 0.5 0.5

Firm A Firm B E(V)

NCF 400 1400 900

New Investment 600 600 600

Dividend 0 800 400New shares 200 0 100

E(Div - NS) = E(NCF - I) = 300.

Date 1 Realisation: Firm B: Div - NS - E (Div - NS) = 500 = NCF - E ( NCF).

Firm A : Div - NS - E (Div - NS) = -500 = NCF - E ( NCF).

88

Lintner Model.

Managers do not like big changes in dividend (signalling).

They smooth them - slow adjustment towards target payout rate.

)..( 11 DivepstTKDivDiv ttt K is the adjustment rate. T is the target payout rate.

Dividend Policy -Lintner Model

0.00

10.00

20.00

30.00

40.00

50.00

1 2 3 4 5 6 7 8

Years

Va

lue

s

FIRM A B CK 0.5 0 1

YEAR EPS DIV DIV DIV

1 30.00 13.25 11.50 15.002 34.00 15.13 11.50 17.003 28.00 14.56 11.50 14.004 25.00 13.53 11.50 12.505 29.00 14.02 11.50 14.506 33.00 15.26 11.50 16.507 36.00 16.63 11.50 18.008 40.00 18.31 11.50 20.00

89

Using Dividend Data to analyse Lintner Model.

In Excel, run the following regression;

ttt cEpsbDivaDiv 1

...)1( 1 epstTKDivKDiv tt

The parameters give us the following information,

a = 0, K = 1 – b, T = c/ (1 – b).

90

Comparison of MM Irrelevance, Gordon Growth, and Signalling.

A. In MM irrelevance, Dividends do not matter: NCF – I is fixed each period. Dividends and NS balance out. Capital freely available.

B. In Gordon Growth, NCF (1-K) = NCF – I = Divs.

No New shares. Increased Dividends => lower re-investment, lower growth => effect on firm value?

C. Signalling. High dividends => high firm value; low dividends => low firm value.

(See Boyesen Case Study.)

91

Section 6: Options and Risk Management.

A call option gives the holder the right (but not the obligation) to buy shares at some time in the future at an exercise price agreed now.

A put option gives the holder the right (but not the obligation) to sell shares at some time in the future at an exercise price agreed now.

European Option – Exercised only at maturity date.

American Option – Can be exercised at any time up to maturity.

For simplicity, we focus on European Options.

92

Factors Affecting Price of European Option (=c).

-Underlying Stock Price S.

-Exercise Price X.

-Variance of of the returns of the underlying asset ,

-Time to maturity, T.

.0,0,0,02

T

cc

X

c

S

c

2

The riskier the underlying returns, the greater the probability that the stock price will exceed the exercise price.

The longer to maturity, the greater the probability that the stock price will exceed the exercise price.

93

Combining options, graphic presentation.

Buying a Call Option.

S

WSelling a put option.

Selling a Call Option. Buying a Put Option.

94

S

WLong in Stock

Short in Stock

Buy a Bond

Sell a Bond

S + P = B + C.

S + P – C = B. => risk-free profile.

Other Combinations: Spread, Straddle, Straps and strips.

See Exercise.

Put-call parity =>.

95

S

W

Long in Stock

Options And Risk Management.

Sell a Call Option.Plus

W

S

+S

- C

S - C

W

S

W

S

Plus buy a put: S + P – C = B.

S + P – C = B.

96

Another Example: Straddle.

Buy a Call Plus buy a Put.W

S

C + P

A straddle loses money for small changes in the stock price, and gains for large changes.

But, in an efficient market, we pay a fair price for this (as always).

97

Equity as a Call Option.

Black and Scholes pointed out that equity is a call option on the value of the levered firm.

If Value of firm exceeds face value of debt (exercise price of call option), equityholders pay the exercise price, and gain the increase in value.

If value of firm is less than face value of debt, option is not exercised.

Risky debt = risk-free debt – put option (B – P).

98

Important Implications for Firm.

Equity is a call option: Value of Equity increases with risk.

Value of Put option increases with risk: Therefore value of debt decreases with risk.

After all, Equity holders have limited liability, and

S = Max [ 0, V – D ]. B – P = Min [ V, D ].

With (B – P) + S = V.

Therefore, if S increases, ( B – P) decreases.

Equity holders will want to choose riskier projects.

99

Pricing Call Options – Binomial Approach.

S=20

q

1- q dS=13.40

uS=24.00

S = £20. q=0.5. u=1.2. d=.67. X = £21.

1 + rf = 1.1.

Risk free hedge Portfolio: Buy One Share of Stock and write m call options.

uS - mCu = dS – mCd => 24 – 3m = 13.40.

M = 3.53.

By holding one share of stock, and selling 3.53 call options, your payoffs are the same in both states of nature (13.40): Risk free.

cq

1- q

Cu = 3

Cd=0

100

Since hedge portfolio is riskless:

.))(1( uf mcuSmcSr

1.1 ( 20 – 3.53C) = 13.40.

Therefore, C = 2.21.

This is the current price per call option. The total present value of investment = £12 .19, and the rate of return on investment is

13.40 / 12.19 = 1.1.

101

Application of Options- Convertible Debt.

Convertible Debt gives the holder the right (but not the obligation) to convert bonds into equity at a future date.

Convertible debt is a combination of straight debt plus a call option.

We saw that straight debt = risky debt – a put option.

CD = D + C = B – P + C .

Implication: Value of Convertible debt increases with risk of firm’s cashflows, and time to maturity.

102

Risk Management.

Types of risk.

-Interest rate risk.

-exchange rate risk.

-operating risks

Integrated risk management approach.

Two Main Questions:-

How do Managers engage in Risk Management?

Should Managers even bother?

103

How to risk manage (Smith and Smithson).

Use of derivatives.

Interest rate, exchange rate instruments.

Meulbroek-

a) Modify firm’s operations

b) Adjust capital structure

c) Employ targeted financial Instruments.

Need for an integrated risk management policy (explain?)

104

Why bother risk-managing? (Meulbroek (2002), Shapiro and Titman

Argument for risk-mgt irrelevance

-A firm’s total risk consists of market risk (beta) and specific risk.

-Well-diversified investors have already got rid of each firm’s specific risk.

-Investors rewarded for holding market risk only (see CAPM).

-Risk Management is at best irrelevant (cannot add value)- (like MM’s capital structure irrelevance).

-At worst, a wasteful negative NPV activity (ie wasted resources, time and effort).

105

Argument for risk-management relevance (Meulbroek (2002), Shapiro and Titman

Risk-management by firm is value-adding;-

a) Inside info may make risk mgt easier for firms than investors.

b) Financial distress.

c) Non-diversified investors (such as managers themselves!!)

d) Risk-mgt and management incentives (eg risk-shifting).

e) Risk-mgt and debt capacity.

106

NPV analysis of risk mgt irrelevance/ relevance.

.......)1()1(1 3

32

210

K

X

K

X

K

XV

K = WACC, includes cost of equity (CAPM).

Investors have eliminated all specific risk – remaining market risk is in K.

Risk mgt will not affect K => cannot add value.

Shapiro and Titman – total risk => financial distress (FD) => reduces expected cashflows X.

Risk mgt reduces total risk=> affects FD and X => value adding.

107

Section 7: Convertible Debt.

-Valuation of Convertibles.

-Impact on Firm Value.

-Why firms issue convertibles.

-When are they converted (call policy)?

Convertible bond -holder has the right to exchange the bond for common stock (equivalent to a call option).

Conversion Ratio = number of shares received for each bond.

Value of Convertible Bond = Max{ Straight bond value, Conversion Value} +option value.

108

Value of Convertible Bond. (Occidental Electric Case Study)

Straight Bond Value Conversion Value

Total Value of Convertible Bond

V

Firm Value Firm Value

Firm Value

Face Value

109

Conflict between Convertible Bond holders and managers.

Convertible Bond = straight debt + call option.

Value of a call option increases with:

Time.

Risk of firm’s cashflows.

Implications: Holders of convertible debt maximise value by not converting until forced to do so => Managers will want to force conversion as soon as possible.

Incentive for holders to choose risky projects => managers want to choose safe projects.

110

Reasons for Issuing Convertible Debt.

Much real world confusion.

Convertible debt - lower interest rates than straight debt.

=> cheap form of financing?

No! Holders are prepared to accept a lower interest rate because of their conversion privilege.

CD =

.)1()1(

.)1()1(

1

1

ND

N

tt

D

D

NC

N

tt

C

C

K

M

K

I

K

PR

K

I

D =

.,, DCDKKMPRII CDCD

111

Alternative Analysis of Irrelevance of Convertible Debt.

Firm DoesBadly.

Firm DoesWell.

Convertible Debt.No Conversion. Conversion.

Compared with:Straight Bonds.

CD cheaperfinancing, lowercoupon rate.

CD expensive,Bonds areconverted,Existing EquityDilution.

Equity. CD expensive. CDs cheaper.

Firm Indifferent between issuing CD, debt or equity.

-MM.

112

Why do firms issue convertible debt?

If convertible debt is not a cheap form of financing, why is it issued?

A. Equity through the Back Door (Stein, Mayers).

-solves asymmetric information problems (see Myers-Majluf).

-solves free cashflow problems.

B. Convertible debt can solve risk-shifting problems.

- If firm issues straight debt and equity, equity holders have an incentive to go for risky (value reducing) NPV projects.

Since CD contains an option feature, CD value increases with risk.

-prevents equity holders’ risk shifting.

113

Convertible Debt and Call Policy.

Callable Convertible debt =>firms can force conversion.

When the bond is called, the holder has 30 days to either:

a) Convert the bond into common stock at the conversion ratio, or

b) Surrender the bond for the call price.

When should the bond be called?

Option Theory: Shareholder wealth is maximised/ CD holders wealth is minimised if

Firm calls the bond as soon as value = call price.

114

Call Puzzle.

Manager should call the bond as soon as he can force conversion.

Ingersoll (1977) examined the call policies of 124 firms 1968-1975.

- He found that companies delayed calling far too long.

- median company waited until conversion value was 44% above call price - suboptimal.

Call Puzzle addressed by Harris and Raviv.

- signalling reasons for delaying calling.

- early calling might signal bad news to the market.

115

Section 8: Takeovers.

Takeovers

Acquisition

Proxy Contest

Merger

Stock Acquisition

1. Merger- must be approved by stockholders’ votes.

2. Stock acquisition- No shareholder meeting, no vote required.

-bidder can deal directly with target’s shareholders- bypassing target’s management.

- often hostile.

-shareholders may holdout- freerider problems.

3. Proxy Contests- group of shareholders try to vote in new directors to the board.

116

Synergy =

Synergy =

Example: Market Value after Merger.

Firm A (bidder): cashflows = £10m, r = 10%. = £100m.

Firm B (target): cashflows = £9m, r = 15%. = £60m.

If A acquires B: Cashflows are expected to increase by £6m P.A. Discount rate 20%.

Synergy = £30m.

= $190m.

).( VVV BAAB

.1 )(

r

CFtt

V A

V AB

V B

117

The NPV of a merger.

Firm A may have to pay a premium to acquire firm B.

If firm A has to pay cost C to acquire firm B,

).()( VCVVVNPV BBAAB

In our example, if C = 70,

NPV of the merger to firm A = 30 - 10 = 20.

Therefore, the gain from synergy can be divided between the bidder and the target - affected by the premium.

(See Clifton Corporation Case Study).

=> models by Garvey and Hanka, and Grossman and Hart.

NPV = Synergy - Premium.

118

Garvey and Hanka: Management of Corporate Capital Structure.

- Hostile takeovers, and US antitakeover laws of 1980’s.

- dynamic defensive capital structure model.

-Results-

A. When takeover is easy => manager defends, increasing leverage => increases firm value => reduces takeover threat.

B. When takeover is more difficult => manager reduces leverage to reduce financial distress.

Optimal debt level maximises firm value.

119

- Manager’s optimal debt level minimises the threat of financial distress and minimises takeover threat.

- Investors’ Optimal debt level D*, maximises firm value.

- Firm has single terminal Cashflow: R +

If no takeover threat, manager chooses D < R + - no financial distress.

As takeover threat increases, manager increases D towards D* => V increases => reduces takeover threat.

.min

120

Take-over Bids and the Freerider Problem (Grossman and Hart (----).

- Market value per share under current management = Q.

- Market value per share under optimal management = V.

Price per share offered by raider = P, with Q < P V.

Freerider problem - If shareholder accepts offer, he gets P.

If shareholder refuses, but bid succeeds, he gets V.

Therefore, all shareholders refuse - bid fails.

Eg: Q = 10, V = 100. P = 20.

Each shareholder will not tender for anything less than 100 -raid fails.

121

Dilution - allows raider to take some of the firm’s value if successful.

Eg: dilution = 10 (lump sum payment to raider).

Successful raid: net value to shareholders = 100 - 10 = 90.

Tender offer = 91. Bid succeeds.

Implication of Garvey and Hanka, and Grossman and Hart.

-Corporate Governance (disciplining) role of Takeovers.

- Takeovers increase firm value (socially desirable).

- Takeovers may be difficult to achieve due to defensive strategy, or freerider price ‘run-ups’.

- Successful takeovers - most of the gains go to the target shareholders.

122

Effects of takeovers on stock prices of bidder and target.

TakeoverTechnique

Target Bidders

TenderOffer

30% 4%

Merger 20% 0

ProxyContest

8% n.a

TakeoverTechnique

Target Bidders

TenderOffer

-3% -1%

Merger -3% -5%

ProxyContest

8% n.a

Successful Bids Unsuccessful Bids

Jensen and Ruback JOFE 1983

123

Valuing a Merger.

• Firm X is bidding for firm Y.

• Firm X current f/c cashflows: £100m P.A.

• Firm Y current F/c cashflows: £50m P.A.

• Risk-free rate 5%.

• Expected return on market 10%.

• Firm X: beta = 1.0.

• Firm Y: beta = 0.8.

124

Post-merger.

• Combined company X + Y: beta = 1.5

• Combined cashflows X + Y: £300m.

• What is synergy value?

• What is gain in shareholder wealth (for X and Y)?

125

Step 1: calculate pre-merger values.

• CAPM: Ke (firm X) = 10%.

• CAPM: Ke (Firm Y) = 9%.

• DVM:

• g=0.

• V0(Firm X) = £1000m.

• V0 (Firm Y) = £555m.

g

gDV

)1(00

126

Step 2: Calculate post-merger value.

• CAPM: Ke (A + B) = 12.5%

• V0 (A + B) = £2400m.

• Synergy Value = 2400 – 1000 – 555 = 845m (Total NPV of merger)

• Which shareholders (X or Y) get this?

127

NPV of the Merger.

).()( BYXXYX VCVVVNPV

).555()5551000(2400 CNPVX

X pays full value: C = 1400 => NPV X = 2400 –1555 – 845 = 0.

NPV Y = 1400 - 555 = 845.

X pays pre-merger value: C = 555 => NPV X = 845.

NPV Y = 555 – 555 = 0.

128

Which is most likely?

• Free-rider problems.

• Defensive use of capital structure.

• Other defenses (poison pills; anti-takeover amendments etc).

• Multiple bidders.

• EMH.

• Real Option approach.

129

Real Option Approach (AK).

• Single Bidder X.• Single Target Y.• Bidder decides whether to make bid.• Target decides whether to accept.• Standard model: X just bids pre-bid value

of Y.• AK model: options to delay for both X and

Y.

130

Optimal bid.

VY Pre. VY Post.

Y’s Minimum acceptable.

X’s Max bid