Corporate Financial Policy2004-2005Introduction
Professor André Farber
Solvay Business School
Université Libre de Bruxelles
Cofipo 2005 01 Introduction |204/18/23
How to finance a company?
• Should a firm pay its earnings as a dividends?
• When should it repurchase some of its shares?
• If money is needed, should a firm issue stock or borrow?
• Should it borrow short-term or long-term?
• When should it issue convertible bonds?
Cofipo 2005 01 Introduction |304/18/23
Some data – Benelux 2004
MktCap€m
Free Float NetDebt€m
NetD/BEq NetD/(D+E)all
NetD/(D+E)NetD>0
DivYield Payout Ratio
Mean 3,125 60% 710 38% 16% 36% 3.0% 29%Median 771 56% 154 42% 15% 29% 2.7% 34%Standard deviation 6,195 26% 1,777 78% 54% 34% 1.9% 43%Minimum 30 10% -1,423 -241% -357% 0% 0.1% -283%Maximum 46,706 100% 12,555 220% 166% 166% 12.7% 100%Percentile 0.25 321 41% -18 -9% -4% 13% 1.6% 7%
0.50 763 56% 156 43% 15% 29% 2.7% 34%0.75 3,468 82% 609 81% 39% 44% 4.0% 49%
# observations 101 101 100 97 100 70 78 99
Cofipo 2005 01 Introduction |404/18/23
Divide and conquer: the separation principle
• Assumes that capital budgeting and financing decision are independent.
• Calculate present values assuming all-equity financing
• Rational: in perfect capital markets, NPV(Financing) = 0
• 2 key irrelevance results:
– Modigliani-Miller 1958 (MM 58) on capital structure
The value of a firm is independent of its financing
The cost of capital of a firm is independent of its financing
– Miller-Modigliani 1961 (MM 61) on dividend policy
The value of a firm is determined by its free cash flows
Dividend policy doesn’t matter.
Cofipo 2005 01 Introduction |504/18/23
Market imperfections
• Issuing securities is costly
• Taxes might have an impact on the financial policy of a company
• Tax rates on dividends are higher than on capital gains
• Interest expenses are tax deductible
• Agency problems
• Conflicts of interest between
– Managers and stockholders
– Stockholders and bondholders
• Information asymmetries
Cofipo 2005 01 Introduction |604/18/23
Course outline
09/02/2005 1. Introduction – MM 1958, 1961
16/02/2005 2. Debt and taxes
23/02/2005 3. Adjusted present value
02/03/2005 4. WACC
09/03/2005 5. Case study
16/03/2005 6. Option valuation: Black-Scholes
23/03/2005 7. Capital structure and options: Merton’s model
13/04/2005 8. Optimal Capital Structure Calculation: Leland
20/04/2005 9. Convertible bonds and warrants
27/04/2005 10. IPO/Seasoned Equity Issue
04/05/2005 11. Dividend policy
11/05/2005 12. Unfinished business/Review
Cofipo 2005 01 Introduction |704/18/23
Practice of corporate finance: evidence from the field
• Graham & Harvey (2001) : survey of 392 CFOs about cost of capital, capital budgeting, capital structure.
• « ..executives use the mainline techniques that business schools have taught for years, NPV and CAPM to value projects and to estimate the cost of equity. Interestingly, financial executives are much less likely to follows the academically proscribed factor and theories when determining capital structure »
• Are theories valid? Are CFOs ignorant?
• Are business schools better at teaching capital budgeting and the cost of capital than at teaching capital structure?
• Graham and Harvey Journal of Financial Economics 60 (2001) 187-243
Cofipo 2005 01 Introduction |804/18/23
Finance 101 – A review
• Objective: Value creation – increase market value of company
• Net Present Value (NPV): a measure of the change in the market value of the company
NPV = V
• Market Value of Company = present value of future free cash flows
• Free Cash Flow = CF from operation + CF from investment
• CFop = Net Income + Depreciation - Working Capital Requirement
Cofipo 2005 01 Introduction |904/18/23
The message from CFOs: Capital budgeting
How freqently does your firm use the following techniques when deciding which project or acquisition to pursue?
Source: Graham Harvey JFE 2001 n=392
0.00% 10.00% 20.00% 30.00% 40.00% 50.00% 60.00% 70.00% 80.00%
APV
Profitability index
Simulation analysis
Book rate of return
Real options
Discounted payback
P/E multiple
Sensitivity analysis
Payback
Hurdle rate
NPV
IRR
Ev
alu
ati
on
te
ch
niq
ue
% always or almost always
Cofipo 2005 01 Introduction |1004/18/23
From Markowitz to CAPM
jfMfj rrrr )(
rf 8%
rM 14%
1 2 Beta
M
P
8%
14%
20%
Sigma
Expected ReturnExpected Return
M
P
2
)~,~cov(
M
Mjj
rr
Security Market Line
Cofipo 2005 01 Introduction |1104/18/23
The message from CFOs : cost of equity
How do you determine your firm's cost of equity capital?
0.00% 10.00% 20.00% 30.00% 40.00% 50.00% 60.00% 70.00% 80.00%
Regulatory decisions
Investor expectations
Dividend discount model
Multibeta CAPM
Arithmetic average historical return
CAPM
% always or almost always
Cofipo 2005 01 Introduction |1204/18/23
CAPM – an other formulation
)(1
)(
fMf rrr
CEV
2
),cov(
M
Mrr
2
),cov()(
)( :Here
M
MfMf
V
rCrrr
CEV
V
VCr
Consider a future uncertain cash flow C to be received in 1 year.PV calculation based on CAPM:
with:
)()),cov(
1( CEV
rCrV M
f
2 :Define
M
fM rr
ff
M
rr
rCCEV
1
equivalentCertainty
1
),cov()(
See Brealey and Myers Chap 9
Cofipo 2005 01 Introduction |1304/18/23
Binomial option pricing model
• Used to value derivative securities: PV=f(S)
• Evolution of underlying asset: binomial model
• u and d capture the volatility of the underlying asset
• Replicating portfolio: Delta × S + M
•
• Law of one price: f = Delta × S + M
SdS
uS fu
fd
Δt
dtr
utr
fMedSDelta
fMeuSDelta
tu
d
teu t
11
1
M is the cash positionM>0 for investmentM<0 for borrowing
r is the risk-free interest rate with continuous compounding
Cofipo 2005 01 Introduction |1404/18/23
Risk neutral pricing
• The value of a derivative security is equal to risk-neutral expected value discounted at the risk-free interest rate
• p is the risk-neutral probability of an up movement
trdu
e
fppff
)1(
du
dep
tr
tredppu )1(
Cofipo 2005 01 Introduction |1504/18/23
State prices – Digital options
• Consider digital options with the following payoffs:
• Using the binomial option pricing equation:
uS dS
Up: vu 1 0
Down: vd 0 1
true
pv
trde
pv
1
Calculation of present values using state prices:
dduu
dutr
du
fvfvf
vve
dSvuSvS
1
Cofipo 2005 01 Introduction |1604/18/23
Using state prices
Calculation of present values using state prices:
dduu
dutr
du
fvfvf
vve
dSvuSvS
1
Cofipo 2005 01 Introduction |1704/18/23
Cost of capital with debt
• CAPM holds – Risk-free rate = 5%, Market risk premium = 6%
• Consider an all-equity firm:
• Market value V 100
• Beta 1
• Cost of capital 11% (=5% + 6% * 1)
• Now consider borrowing 20 to buy back shares.
• Why such a move?
• Debt is cheaper than equity
• Replacing equity with debt should reduce the average cost of financing
• What will be the final impact
• On the value of the company? (Equity + Debt)?
• On the weighted average cost of capital (WACC)?
Cofipo 2005 01 Introduction |1804/18/23
Modigliani Miller (1958)
• Assume perfect capital markets: not taxes, no transaction costs
• Proposition I:
• The market value of any firm is independent of its capital structure:
V = E+D = VU
• Proposition II:
• The weighted average cost of capital is independent of its capital structure
WACC = rAsset
• rAsset is the cost of capital of an all equity firm
Cofipo 2005 01 Introduction |1904/18/23
MM 58: Proof by arbitrage
• Consider two firms (U and L) with identical operating cash flows X
VU = EU VL = EL + DL
Current cost Future payoff
• Buy α% shares of U αEU = αVU αX
______________________________
• Buy α% bonds of L αDL αrDL
• Buy α% shares of L αEL α(X – rDL)
______________________________
• Total αDL + αEL = αVL αX
• As the future payoffs are identical, the initial cost should be the same. Otherwise, there would exist an arbitrage opportunity
Cofipo 2005 01 Introduction |2004/18/23
MM 58: Proof using CAPM
• 1-period company
• C = future cash flow, a random variable
• Unlevered company:
• Levered (assume riskless debt):
• So: E + D = VU
f
MU r
rCCEV
1
),cov()(
f
M
r
rDivDivEE
1
),cov()(
Dr
rCCE
r
rDrCDrCEE
f
M
f
Mff
1
),cov()(
1
)],)1(cov([])1([
=VU
Cofipo 2005 01 Introduction |2104/18/23
MM 58: Proof using state prices
• 1-period company, risky debt: Vu>F but Vd<F
• If Vd < F, the company goes bankrupt
Current value Up Down
Cash flows VUnlevered Vu Vd
Equity E Vu – F 0
Debt D F Vd
dduuUnlevered VvVvV
0)( duu vFVvE
ddu VvFvD Unlevered
dduu
dduuu
V
VvVv
VvFvFVv
DEV
][)]([
Cofipo 2005 01 Introduction |2204/18/23
Weighted average cost of capital
Value of all-equity firm
Value of equity
Value of debt
V (=VU ) = E + D
rEquity
rDebt
rAsset
V
Dr
V
Err DebtEquityAsset
WACC
Cofipo 2005 01 Introduction |2304/18/23
Using MM 58
• Value of company: V = 100
• Initial Final
• Equity 100 80
• Debt 0 20
• Total 100 100 MM I
• WACC = rA 11% 11% MM II
• Cost of debt - 5% (assuming risk-free debt)
• D/V 0 0.20• Cost of equity 11% 12.50% (to obtain WACC =
11%)
• E/V 100% 80%
Cofipo 2005 01 Introduction |2404/18/23
Why are MM I and MM II related?
• Assumption: perpetuities (to simplify the presentation)
• For a levered companies, earnings before interest and taxes will be split between interest payments and dividends payments
EBIT = Int + Div
• Market value of equity: present value of future dividends discounted at the cost of equity
E = Div / rEquity
• Market value of debt: present value of future interest discounted at the cost of debt
D = Int / rDebt
Cofipo 2005 01 Introduction |2504/18/23
Relationship between the value of company and the WACC
• From the definition of the WACC:
WACC * V = rEquity * E + rDebt * D
• As rEquity * E = Div and rDebt * D = Int
WACC * V = EBIT
V = EBIT / WACC
Market value of levered firm
EBIT is independent of leverage
If value of company varies with leverage, so does WACC in opposite direction
Cofipo 2005 01 Introduction |2604/18/23
MM II: another presentation
• The equality WACC = rAsset can be written as:
• Expected return on equity is an increasing function of leverage:
E
Drrrr DebtAssetAssetEquity )(
rA
D/E
rEquity
11%
rDebt
5%
0.25
12.5%
WACC
Additional cost due to leverage
Cofipo 2005 01 Introduction |2704/18/23
Why does rEquity increases with leverage?
• Because leverage increases the risk of equity.
• To see this, back to the portfolio with both debt and equity.
• Beta of portfolio: Portfolio = Equity * XEquity + Debt * XDebt
• But also: Portfolio = Asset
• So:
• or
DE
D
DE
EDebtEquityAsset
E
DDebtAssetAssetEquity )(
Cofipo 2005 01 Introduction |2804/18/23
Back to example
• Assume debt is riskless:
• Beta asset = 1
• Beta equity = 1(1+20/80) = 1.25
• Cost of equity = 5% + 6% 1.25 = 12.50
E
V
E
DAssetAssetEquity )1(
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