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1
Advanced Company Finance.
BBA4 Semester 1, 2003
1. Brief Revision of BBA2 Corporate Finance.
2. Investment Appraisal, decision trees, and real options.
3. Cost of Capital, Capital Structure, Firm Value.
4. Optimal Capital Structure - Agency Costs, Signalling.
5. Dividend Policy.
6. Risk management.
7. Convertible Debt.
8. Mergers and Takeovers.
2
Income Statement.
Revenue
-Variable Costs
-Fixed costs
-Depreciation
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.
3
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).
4
Revision of BBA2 Course
The firm has two decisions: investment decisions and financing decisions.
New Investment Appraisal (Investment decision).
We examined 4 possible methods:
Accounting Rate of Return, Payback, NPV, IRR.
POSITIVE NPV Increases Shareholder Wealth.
.....)1()1(1 3
32
21
r
X
r
X
r
XINPV
r
XINPV Perpetuities.
5
Revision of BBA2 Course (Continued).
Discount Rate in NPV = Investors’ required return = cost of capital.
Estimating Cost of Capital:
Cost of equity: CAPM: ])([)( fmf rrErrE
Investors with well-diversified portfolios only get rewarded for holding systematic or market risk. They are not rewarded for holding diversifiable or specific risk.
Security Market Line.
The higher the beta, the higher the cost of equity.
6
V
tKdVdKeVeWACC
)1(..
Revision of BBA2 Course (Continued).
WACC = cost of equity (from CAPM) x % of equity in capital structure + after tax cost of debt x % of debt in capital structure.
Values here are market values.
Capital Structure- the firm’s financing decision.
The amount of debt and the amount of equity.
Miller-Modigliani Irrelevance.
7
Revision of BBA2 Course (Continued).
Capital Structure and Firm Value.
MM irrelevance: MM Diagrams.
Without tax, firm value is independent of capital structure.
With Tax: 100% debt maximises firm value!!!
Debt capacity, fin distress, agency costs, signalling.
New BBA4 capital structure topics: agency costs+signalling.
Product market competition.
Behavioural Finance.
Finally, in BBA2, we looked at options. We will use in BBA4!
8
Options- Revision
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.
.0,0,0,02
T
cc
X
c
S
c
9
Buying a Call Option.
S
WSelling a put option.
Selling a Call Option. Buying a Put Option.
10
Options: Black Scholes Model.
-Binomial Approach: discrete time periods. Large number of inputs.
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
37
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)
38
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
39
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.
40
SECTION 2: Cost Of Capital (revision).
The cost of capital = investors’ required return on their investment in a company.
Investors are risk averse.
The higher the risk, the higher the required return.
...
de
ddee
VV
KVKVWACC
41
Cost of Capital: Revision (continued).
Estimating the cost of equity.
DVM: .1 gV
DivK
ee .1
gK
DivV
ee =>
CAPM: ])([)( fmf rrerrE
APT: ikikiii FbFbRER ....)( 11
Practice: rule of thumb: E(r ) = risk-free rate plus an element for risk.
42
Cost of Equity (continued)
CAPM
.])([)( fmfi rrErrE
quantity of risk.
)(rE
fr
1
)( mrE
Security Market Line.
43
Estimating Cost of Equity Using Regression Analysis.
We regress the firm’s past share price returns against the market.
.
.
i
imii
b
rbar
ir
mr
44
Using Probability assessment to estimate cost of capital.
A new project has the following data,
22
2222
)80.124(24.149.232
mi
59.4089.19149.232
Probability % Returns % Returns E(ri ) E(rm ) E(ri-mean)E(rm-mean)on project on market %
Combining cost of equity with cost of debt to obtain WACC.
.)1(..
de
ddee
VV
tKVKVWACC
-Ke only rewards investors for systematic risk.
-Must use market values of debt and equity (not book values).
-WACC is the marginal cost for new investments. Therefore, WACC may be different for different projects (why?).
46
Risk-adjusted required returns- The Pure-play technique.
(Shapiro Pg 324)
-technique for determining different WACC’s for different projects or divisions.
Step 1: Identify pure-play firms: publicly traded firms similar to your firm’s project or business.
Step 2: determine betas for pure-plays- from return data (see BBA2) or from already published data.
-these are the equity betas (depends on business and financial risk).
47
Pure-Play (continued).
Step 3: Adjust for leverage.
The pure-play’s debt ratios may differ from your own capital structure.
Convert the levered equity beta into unlevered beta (asset beta).
.)1(1ED
t
LU
Step 4: Relever the asset beta (to reflect your firm’s financing mix):
** *)1(1[
E
DtUL
48
Pure-Play (continued).
Step 5: Calculate the Project’s (or division’s) cost of equity- Use CAPM.
Step 6: Calculate the project’s required rate of return (WACC).
Limitations.
Different divisions might have different debt capacities- may affect target capital structures.
Pure Play assumes no interaction between divisions.
Movement from single rate to multiple rates may face managerial resistance (why?)
49
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
50
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
51
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
52
SECTION 3: Value of the Firm and Capital Structure
Revision of BBA2.
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).
53
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
EU
K
Bk
eK
NIVV
WACC
TNCFBTVV
VTNCF
V
Irrelevance Theorem: Without Tax, Firm Value is independent of the Capital Structure.
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
56
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.
57
Combining Tax Relief and Debt Capacity (Traditional View).
D/E D/E
V
K
58
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.
59
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
60
Jensen and Meckling (1976)
B
V
V*
V1
B1
A
If manager owns all of the equity, equilibrium point A.
Slope = -1
61
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
62
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
63
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?
64
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
65
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*
66
Other Agency Cost Reasons for Optimal Capital structure.
-Cashflow retention when firm has both high optimism and good investments.
- cash flow payouts when firm has high optimism and bad investments.
89
Rational capital budgeting in an irrational world. (Stein 1996).
-Manager rational, investors over-optimistic.
- share price solely determined by investors.
-How to set hurdle rates for capital budgeting decisions?
- adaptation of CAPM, depending on managerial aims.
- manager may want to maximise time 0 stock price (short-term).
-May want to maximise PV of firm’s future cash flows (long term rational view).
90
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.
91
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
92
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
tt
tt INCFNSDivV
93
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.
94
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.
95
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.
96
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
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.)
106
Section 6: 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?
107
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?)
108
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).
109
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.
110
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.
111
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.
112
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
113
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.
114
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
115
Example of Valuation of Convertible Bond.
October 1996: Company X issued Convertible Bonds at October 1996: Coupon Rate 3.25%, Each bond had face Value £1000.
Bonds to mature October 2001.
Convertible into 21.70 Shares per per bond until October 2001.
Company rated A-. Straight bonds would yield 5.80%.
Now October 1998:
Face Value £1.1 billion.
Convertible Bonds trading at £1255 per bond.
The value of the convertible has two components; The straight bond value + Value of Option.
116
Valuation of Convertible Bond- Continued.
If the bonds had been straight bonds: Straight bond value =
PV of bond =83.932
)058.1(
1000
)058.1(
25.163
3
5.0
t
tt
Price of convertible = 1255.
Conversion Option = 1255 – 933 = 322.
Oct 1998 Value of Convertible = 933 + 322 = 1255. = Straight Bond Value + Conversion Option.
117
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.
118
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.
119
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.
120
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.
121
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.
122
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
123
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.
124
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.
125
- Manager’s optimal debt level minimises the threat of financial distress and minimises takeover threat.