AC210 Corporate Finance Lecture Notes_2

8/8/2019 AC210 Corporate Finance Lecture Notes_2

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AC210: Corporate Finance

Norvald Instefjord

[email protected]


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Introduction to Corporate Finance

What is finance?

What is the distinction between financial

and real assets? What is corporate finance?

What is the role of financial assets in

corporate finance?


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Week 1Financial Markets and Financial

Instruments How do firms finance their investments?

Earnings (free cash flow, internal capital)

Equity capital (external public or private) Debt capital (external)

Public and private capital

Trading of public capital New issues

Secondary trading


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Equity Issues

First time a firm seeks public equity iscalled an initial public offering (IPO)

Primary issue: new equity is issued Secondary issue: existing private equity is

sold to outside investors (most privatisationstake this form)

Legal and underwriting services provided byinvestment banks


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Debt Issues

Bank loans not publicly traded

Corporate Bonds traded actively in the

secondary market

Debt capital and equity capital account for

most of the firms financial capital


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Definition of Debt

Fixed claim

Specifies what needs to be repaid to theinvestor and when

Default risk risk that the repayment plan isnot fulfilled

Conversion options covenants that allow

debt to be reclassified as equity


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Definition of Equity

Residual claim Does not specify a repayment plan

Repayment is defined as the residual:whatever is not claimed by other claimholders should go to the equity holders

Voting rights: Equity holders normally have aright to vote on important corporate decisions

Mergers, takeovers Large investments

Board representation


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Trends in Corporate Finance

Globalisation

Deregulation

Financial innovation Technological advances in the financial

system

Securitization


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What you should take home

You should be able to Understand the distinction between a fixed claim and

a residual claim

List the main attributes of a debt claim List the main attributes of an equity claim

Describe the ways in which firms raise funds for newinvestment

Describe the difference between private and public

equity Describe the difference between bank loans and

corporate bonds


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Readings

Grinblatt/Titman: Financial Markets andCorporate Strategy

Ch 1: overview of the process of raisingcapital for investment

Ch 2: overview of the process of raising debtcapital

Ch 3: overview of the process of raising equitycapital


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Problems

1. Why do firms use underwriters whenthey issue new equity?

2. In what ways do you think it matters thatdebt holders have a fixed claim whenequity holders have not?

3. In what ways do you think it matters thatequity holders have voting rights whendebt holders have not?


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Review problems

1. Invest 95 and sell for 102 what is the return?

2. Invest 95 and sell for 102. Each transaction is chargeda 1% trading commission what is the return?

3. Invest 95 and sell for 102. You receive additionalinterest payments/dividends of 2 during the holdingperiod. What is the return?

4. Invest 95 and sell for 110 three years later what isthe annual return on your investment?

5. Invest 95 now and another 98 next year. In thefollowing year you sell your investment for a total of202. What is the annual return on your investment?


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Week 2:Valuing Financial Assets: Portfolio

Tools Tool box Expected portfolio return Portfolio variance Covariance between the return on two assets

Optimal investment Fair price of an asset means that the value equals

the purchasing price Even if prices are fair there are still ways of

investing your money that is better than others Risk Aversion Investors demand compensation for including risk in

their portfolio


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Portfolio weights

A portfolio of financial assets can be representedin a number of ways

The number of shares held in the various stocks (e.g.

1000 shares in BT, 250 shares in Marks&Spenceretc.)

The dollar-value held in the various stocks (e.g.2,500 in Lloyds Bank, 10,000 in Jarvis etc.)

As portfolio weights: the dollar-weight of the variousstocks (e.g. if total portfolio is 100,000, then theportfolio weight of Lloyds is 0.025 and the portfolioweight of Jarvis is 0.1 etc.)


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From portfolio weights to portfolio

expected return and variance To determine the expected return and

variance of a portfolio we need to know

The portfolio weights The expected return on the individual assets

The variance of the return on the individualassets

The covariance between the return on anypair of assets


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Expectation, Variance and

Covariance Expected return (average return) is a locationmeasure

Variance of return is a spread measure

Covariance is a measure of how the return oftwo assets are related (they can move in thesame or opposite directions, or they can beuncorrelated)

If the returns move in the same directions,

covariance is positive, if the returns move in theopposite directions, covariance is negative, andif uncorrelated, covariance is zero


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The input data for a portfolio

of N assets N expected returns N variances

N(N-1)/2 covariances

Plus N portfolio weights

For FTSE100 there are therefore100+100+100(99)/2 = 5150 data points thatneed to be estimated even before working outthe portfolio weights


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Formulas

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Covariance and Correlation

Covariance is a measure of relatednessthat depends on the unit of measurement,so if the return is measured as a percent(e.g. 10 percent) or as a desimal (e.g.0.10) the covariance will be different

Correlation is a measure of relatedness

that is normalized to be independent of theunit of measurement


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Covariance and Correlation

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The Mean-Standard DeviationApproach to Investment

Risk averse investors dont like risk

Variance averse investors dont like risk that comes asvariance

This is not the same in general variance aversion is aspecial case of risk aversion

Portfolio theory takes the variance aversion approach which in practice means that we assume investors wish

to maximize their expected return given a certainvariance, or minimize their variance given a certainexpected return


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Mean-Standard Deviationfor Two-Asset Investments

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Mean-Std Dev for Portfolios of theRisk Free Asset and a Risky Asset

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Covariance as Marginal Variance

We can interpret the covariance betweenthe return on a stock and the return on aportfolio as the stocks marginal variance

That is, if we increase the stocks portfolioweight marginally, the portfolio variancewill increase by approximately twice the

stocks covariance with the portfolio


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Algebraic proof

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What to take home

Understanding of expected values, variances,and covariances

Understanding of expected return and variance

for a portfolio Understanding of risk aversion and variance

aversion

Understanding of the portfolio frontier

Appreciation of the linearity of expected returnand standard deviation for portfolios consistingof the risk free asset and a risky portfolio


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Readings

Chapter 4 in Grinblatt/Titman


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Problems

1. Variance: Prove that E(x-E(x))2=Ex2-(E(x))2

2. Covariance: Prove that E(x-E(x))(y-E(y))=Exy-E(x)E(y)

3. Take a time series of returns 0.05, -0.03,0.10, 0.04, -0.10, 0.20. Estimate theexpected return and the variance ofreturn.


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Week 3:From Mean-Variance to the CAPM

Capital Market Line

Finding the market portfolio

Two-fund Separation

Optimal diversification

Market vs idiosyncratic risk

CAPM expected returns relationship

Expected return on assets depend on theircovariance (i.e. their relatedness) with the marketportfolio

Estimating beta risk


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Capital Market Line

The line that goes through the risk freeasset and the tangency portfolio

Identification? Maximization procedure

Simplifying trick, the excess return on anyasset divided by its covariance with the

tangency portfolio, is constant


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Maximization programme to findthe Capital Market Line

We can identify the frontier portfolios ofrisky assets

Consider investments consisting of the riskfree asset and a frontier portfolio theseare represented by straight lines

For the frontier portfolio that is thetangency portfolio, the angle of the straightline is the steepest


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Capital Market Line cont..

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Capital Market Line cont..

The maximization programme normallyleads to a fairly complicated equation with two risky assets we get a quadraticequation to solve

In the class exercises you will be asked tohave a go at such a problem


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Simplifying trick: finding theCapital Market Line

We know the expected return on all riskyassets and the risk free return

The difference between the two is calledthe excess return for the asset

The excess return, divided by itscovariance with the tangency portfolio, isalways constant


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Capital Market Line

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Example

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Example cont..

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CAPM: Risk and Return

Since the excess return divided by thecovariance with the tangency portfolio isconstant across assets, we can derive

important relationships between risk andreturn

The covariance with the tangency portfoliois, if solved for the tangency portfolio itself,equal to the variance of the tangencyportfolio


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Risk and Return

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Security Market Line

The expected return of securities is linearin their beta-factors

In the (beta,expected return) plane, theline crossing through (0,rF) and (1,E(rT)) iscalled the security market line


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Properties of betas

Beta is linear: the beta of a portfolio ofsecurities equals the portfolio-weightedaverage of the betas of the individualsecurities

An implication is that the beta of theassets of the company equals the value-

weighted beta of the liabilities of thecompany


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Tracking portfolios

A portfolio tracks another perfectly if thedifference in the returns of the portfolios isa constant (possibly zero)

Imperfect tracking: A portfolio consisting ofa weight (1-b) in the risk free asset and aweight b in the tangency portfolio tracks a

stock with beta =b, because the twoshould have the same expected return


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Tracking Errors

The two investments should have the sameexpected return, which implies that the trackingerror has zero expectation and zero value

Of course, investors do not like risk so theychoose to hold the tracking portfolio instead ofthe stock

Because such diversification is free of cost, thetracking error is also free of cost (i.e. it has zerovalue)


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Estimating the risk free return

For risk free return use government bondor government bill data (long or short terminstruments backed by the government)

The return offered on such instruments isa good proxy for the actual risk free return

Alternative, use the average return of a

zero-beta risky stock, or the intercept withthe y-axis if no zero-beta stock exists


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Estimating market risk premia

Estimate the long-run average return on a broadstock market index and subtract the risk free rate

Both the average stock market index return and

the risk free return change over time The change in the difference is more volatile

than the changes in the individual time series.

Therefore, estimate the long-run average index

return first. Do not estimate the differencebetween the market return and the risk free ratedirectly


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Beta Adjustment

Bloomberg adjustment Adjusted beta = .66 times Unadjusted beta +

.34 times One

Rosenberg adjustment Adjustment also incorporates fundamental

variables (industry variables, companycharacteristics such as size, etc..)

Also betas are adjusted sometimes to takeinto account infrequent trading problems


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What to take home

Two-fund separation

Capital Market Line vs Security Market

Line Risk-Return relationships

Tracking portfolio

Parameter estimation: problems andcurrent practice


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Readings

Grinblatt/Titman ch 5


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Problems

What is the tracking portfolio for a realasset?

How would you estimate the beta of theassets of a firm that has traded debt andequity?

How would you estimate the beta of a

company that has never traded?


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Week 4: From CAPM to ArbitragePricing Theory

Main purpose is to extend the valuationapproach into more advanced and flexiblevaluation models

CAPM can be thought of as a one-factor model(returns are determined by movements in themarket portfolio only) but has importantempirical problems (systematic deviations frompredictions)

APT extends to multi-factor pricing that canmitigate some of the CAPMs empirical problems


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Risk Decomposition

The Market Model

One-factor (the return on the market portfolio)

Related to the CAPM model

The regression estimates of the market modelgenerates raw beta-estimates for the CAPM

Risk Decomposition

Systematic (market) risk: asset risk that is explained

by market movements Unsystematic (diversifiable, idiosyncratic) risk: asset

risk that cannot be explained by market movements


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Market model regression

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Risk Decomposition

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APT: The arbitrage principlebehind factor models

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APT: Factor pricing

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Multi-factor models

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We do not know whatthe factors are!

Can be evaluated statistically using amethod called factor analysis

The output generates portfolios associatedwith each factor

Can use firm characteristics ormacroeconomic variables as proxies forthe factors


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Factor betas

The betas determine the assets sensitivity to thefactors

A high loading on factor number 2 means that

the asset is particularly sensitive to risksassociated with factor 2

Factor models extends into portfolio analysis

since the factor betas of portfolio is just thevalue-weighted average factor beta for theindividual assets in the portfolio


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Factor models: computing thevariance-covariance structure

Recall that computing the variance-covariancestructure requires a large number of estimates

For N assets, N variance estimates and N(N-1)/2

covariance estimates N=100, 100 variance estimates and 100(99)/2 =

4950 covariance estimates

Using the market model, we can work out thecovariance structure from the beta estimates, i.e.from the N beta estimates


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Covariance structure estimation

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Variance estimation

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Tracking Portfolio

Objective: to design a portfolio that has certainfactor betas (or factor loadings)

Why? The use of tracking portfolios are many

Risk management: if the company is subject to risksbeyond its control, e.g. currency risk, it may create atracking portfolio that offsets the risk

Capital allocation: the company may wish to allocate

capital to investments that yield a greater return thantheir tracking portfolio and to reduce its exposure toinvestments that yield a smaller return than theirtracking portfolio


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Designing a Tracking Portfolio

First, determine the number of relevant factors(guesswork, statistical analysis)

Second, determine the factor betas of the

investment you wish to track (statistical analysis,comparison with existing traded companies)

Third, gather a collection of different assets withknown factor loadings

Forth, calibrate your portfolio such that theportfolio factor beta equals the target factor betafor each factor


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Example

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Applying Pricing Theory

Use pricing models to investment analysis(optimal investment strategies in financialmarkets diversification)

Use pricing models to calibrateinvestments (design of tracking portfolios)

Use pricing models as a benchmark forreal investment (comparing realinvestment returns to the return ontracking portfolios)


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Readings

Chapter 6 in Grinblatt/Titman


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Problem

There are three relevant factors drivingasset returns The factor structure of the debt of the

company is (0.01, 0,0) The factor structure of the equity of the

company is (2,5,1)

The company consists of 1/3 debt and 2/3

equity What is the factor structure of the

companys real assets (investments)?


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Week 5: Investment Analysis thecase of Risk Free Projects

Apply pricing technology to realinvestment analysis

Net Present Value Rule

Complications

Sunk cost

Opportunity cost

EVA and IRR


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Fisher Separation

With different tastes, why should investors agreeon investment policy?

Long-term vs short term

Risky vs Risk free Fisher separation

Agreement is optimal regardless of taste

Net present value rule: Invest in all projects that cost

less than the value of the projects tracking portfolio NPV = PV(future investment) Investment cost


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Ingredients

Cash flows of our investment

Investment cost

Discount rates (if risk free projects use arisk free discount rate)

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Present Value = sum of discountedcash flows

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Net Present Value

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NPV and Arbitrage

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Value Additivity of NPVs

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Mutually Exclusive Projects

This is an either-or situation you can invest inproject A or you can invest in project B, but youcannot invest in both at the same time

Both projects may have positive NPV so areworthwhile on their own

Either-or situations often arise naturally. Forinstance, all timing decisions are mutuallyexclusive. You can invest now or you can investin the future, but you cannot invest both now andin the future.

Whi h j t t h h th


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Which project to choose when theyare mutually exclusive

The choice criterion is to maximize the netpresent value of investment.

Therefore, if you have two or moremutually exclusive projects to choose fromyou should choose the one with the mostpositive NPV.


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Profitability Index

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Example

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Economic Value Added

EVA is a profitability measure that has becomewidely used in corporations initially to replaceaccounting earnings or profit measures

Accounting measures do not always measureeconomic performance (depreciation cost, forinstance, is not a cash flow and should not beincluded in project evaluation)

Accounting measures are therefore not directlyconsistent with NPV

Economic Value Added is consistent with NPV


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EVA: Definition

Three components

Cash flow

Change in asset base

Economic return on assets

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Value


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EVA, cont.

Investment of 100

The first year cash flow is 50

The second year cash flow is 150

Discount rate is 10%

Assets are depreciated by 50% in the firstyear and by 100% in the second year.

NPV = -100 + 50/1.1+150/1.12=69.42


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IRR: Internal Rate of Return

Often managers base investment decision onthe IRR instead of the NPV

The rule is: if IRR is greater than the discountrate (i.e. the cost of capital) then adopt theproject

In many cases this leads to the same investmentdecision, as IRR is greater than the discount rateonly if the NPV is positive

In other cases this is not true however, so to besafe always use NPV or EVA calculations


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Example

Investment cost = 100

First years cash flow = 150

Discount rate 10%

NPV = -100+150/1.1=36.36

IRR: 0=-100+150/(1+IRR) yields 50%

Since 50% > 10% (IRR > discount rate) it isoptimal to adopt the project


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Problems with IRR

IRR criterion is sensitive to the type of cash flow(asset or liability?)

IRR is not unique in general (for T period

projects there can be up to T different IRRs) IRR is not appropriate for mutually exclusive

projects as small projects with high IRR andsmall NPV might then be preferred to large

projects with low IRR and large NPV

IRR and mutually exclusive


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IRR and mutually exclusiveprojects

Discount rate 2%

Project A: -10, -16, +30

Project B: -10, 2, 11

NPV(A) = 3.149

NPV(B) = 2.534

IRR(A) = 10.79%

IRR(B) = 15.36%


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Important points

Fisher separation

NPV definition

NPV with mutually exclusive projects

(either-or) NPV with budget constraints

EVA and NPV

IRR IRR pitfalls


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Readings

Grinblatt/Titman chapter 10


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Test for next week:

Readings chapter 4, 5, 6 and 10 Important formulas

CAPM: exp return = risk free plus risk adjustment Beta-factor: covariance/variance

Factor models: exp return = risk free plus riskadjustment

Risk free real investments NPV rule Profitability Index EVA IRR


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Very important formulas

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Week 6: Investing in Risky Projects

Applying the CAPM and APT in the capitalbudgeting process

Key problem: estimating the cost of capitalfor risky projects

Applying CAPM and APT

Using comparison firms

The dividend discount model


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Risk Adjusted Discounting

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tperiodin)(get)llat we'exactly whknownotdo(weflowcashfutureexpectedtheompute

!

! F

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Fundamental problem: Estimating


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Fundamental problem: Estimatingthe beta factor

Betas for traded equity are easy to estimate we simply regress equity returns on the indexreturn, and possibly adjust to take into accountestimation error (e.g. Bloomberg adjustment)

Betas for projects are much more difficult toestimate as there simply does not exist a tradinghistory

Possible solution: use comparison firms (firms

we imagine has similar risk profile to the projectin question)

f


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Using comparison firms

Asset base needs to be sufficiently similarto the planned investment

We need to adjust for leverage effects (the

comparison firm may have debt) In general, it is only the equity beta of the

comparison firm we can estimate but we arereally interested in the asset beta

The more the firm borrows, the higher theequity beta (even though the asset betaremains the same)

Adj i f l


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Adjusting for leverage

termleverage

aplusbetaassettheequalsbetaequityEstimated

)(

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Implementing risk adjusted


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Implementing risk adjusteddiscounting with comparison firms

08.10.1

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theseofbetasequityThes.Wendyandsc onald

Chicken,sChurchofbetaaveragethehasproject

!

!

!

C t


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Cont

)084.0(78.004.01055.0isprojectfor therate)(discountcapitalofCost

8.4 .premiumriskmarketand4ratefreeRisk

3

85.077.072.078.0betaprojectbetaverage

!

!!!

A l i APT


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Applying APT

tKKF

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CECEPV

)1(

)(

))((

bygivenareluespresent vasomodel,factoraby

capitalofcosttheestimatesmodelAPTThe

11 PFPF ! .

APT and CAPM vs Alternative


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APT and CAPM vs Alternativemethods

A drawback with the APT and CAPMmodels is that they require a number ofestimates: the risk free rate of return, the

beta factor(s), the market risk premiumand the factor risk premia.

It can in some circumstances be better towork with simpler model. The dividend

growth model is an alternative to the APTand CAPM.

Di id d Di t M d l


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Dividend Discount Model

yielddividenddividendsingrowth

)1(

)1(

)1()1()1(

etc...,)1(

)1(

0

1

10

2

11

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210

221

110

!!

!

!

!

!

!

S

divgr

gr

divS

r

gdiv

r

div

r

div

r

divS

r

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rSdivS

..


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N t k di i i l


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Network division example

36.0

78.05.05.0

99.075.025.0

that

knowwesimilar,lysufficientaredivisionsnetwork

-nonIfdivisions.network-nonfrom50%division,

networkfromvalueof50%0.78,betaasset:iacom

divisions.network-nonfrom75%division,networkfromvalueof25%0.99,betaasset:lectricGeneral

!

!!

!!

Network

networkNonNetworkViacom

networkNonNetworkGE

F

FFF

FFF

Pitfalls in using the comparison


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g pmethod

Project betas not the same as firm betas:mature projects generally lower beta thanR&D projects etc

Growth opportunities are usually thesource of high betas: company value oftensignificantly linked to future growth

opportunities as opposed to currentinvestments

E l


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Example

Investment cost 100,000

Annual running cost 5,000 for 5 years

Expected revenue stream 50,000 for 5years

Beta-risk of revenue stream 1.2

Risk free return 5%

Expected market return 12%

E ample cont


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Example cont

project.adoptTherefore,

051.5251.152100

51.15216.17465.21

)134.1(50)134.1(50)134.1(50)134.1(50)134.1(50

)05.1(5)05.1(5)05.1(5)05.1(5)05.1(5

4.13)512(2.1

5:streamrevenuefor theratediscountThe

free )riskassumedbecancoststhe(as5:costsrunningforratediscountThe

54321

54321

"!!

!!

!

!

NPV

PV

Comparison method example


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Comparison method, example

A firm with equity currently valued at 100,000and outstanding debt worth 50,000 holds 25%cash and 75% of a risky asset on its balancesheet

The equity beta is 1.5 You consider investing in a project very similar

to the risky asset owned by this firm The risk free rate is 5% and the expected return

on the market is 12% Work out the project beta and the cost of capital

for your project

Comparison method cont


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Comparison method cont

14.335 )-1.33(125capitalofCost

33.175.01

75.0)0(25.0betaassetTotal

1

100

501

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betaassettotalThe

0toclosebetaahasbalancecashthat theassumealsoand0,tocloseveryisbetadebtssume

!!

!!

!

!

!

RiskyAsset

RiskyAsset

F

FF

F

Readings


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Readings

Grinblatt & Titman chapter 11

I have not emphasized the certaintyequivalent method

Week 7: Taxes and Financing


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Week 7: Taxes and Financing

Irrelevance in the absence of transactioncosts and taxes (Modigliani-Miller)

Financing choices not neutral to taxation:

Level: corporate vs private tax rates

Timing: dividends can be deferred whereasinterest payments on debt cannot

Modigliani Miller


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Modigliani-Miller

The operating cash flow is divided into twocomponents Cash flow to debt holders

Cash flow to equity holders Fundamental question: Does it matter how

the split is made?

If it does we can create value also throughfinancing choices (not only throughinvestment choices)


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MM cont


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MM cont

Consider two versions of the same firm one version is U for unlevered (with nodebt) and the other version L for levered

(with debt) The firms have otherwise the same

operating cash flow X

The unlevered firm has value VU and thelevered firm value VL

MM cont


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MM cont

The fundamental question is whether VU and VLdiffer

The cash flows of firm Us equity holders issimply X

The cash flow of firm Ls debt holders is (1+r)Dto the firms debt holders and X-(1+r)D to thefirms equity holders, in total a cash flow of Xalso

The value of L is the combined value of the debtand the equity

MM cont


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MM cont

Suppose VL is smaller than VU Then an investor can buy a 10% holding of Ls debt and

a 10% holding of Ls equity, which entitles the investor toa 10% share in the total cash flow X. He would then go

to the market and sell 10% of the cash flow X, which isvalued at 10% of the value of U. This leaves him withzero future liability.

His trading gains are 10% of the difference between VUand VL, which we have assumed is positive

This cannot be possible in an arbitrage free market, sowe can conclude that VL must be equal to or greater thanVU


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What about risky debt?


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What about risky debt?

When the corporate debt contract is risky it maybe difficult to find a synthetic corporate debtcontract if a real one does not exist

We must assume, therefore, that the markets

are sufficiently complete in order to concludethat financing does not matter Complete market = a market where the

dimensionality of the asset structure equals thedimensionality of the uncertainty structure

If there are two states of nature (e.g. good andbad) then it suffices with two distinct assets tomake the market complete


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Taxes: Another important factor


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Taxes: Another important factor

The tax system is generally fairly complexwith different tax rates for differentindividuals and institutions, and for

different types of income Therefore, it may be scope for tax

arbitrage profits in financing

After tax cash flow analysis


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After tax cash flow analysis

A constant after tax discount rate r

Tax rate for personal income from debt tD Tax rate for personal income from equity tE Corporate tax rate tC

Earnings before taxes and interest payments X Earnings before taxes (X kD) (k coupon rate, D

nominal amount borrowed)

After tax personal income from debt kD(1-tD)

After tax earnings (X-kD)(1-tC) After tax personal income from equity (X-kD)(1-tC)(1-tE)

Algebra


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Algebra

benefitstaxdiscountedfirmunleveredalue

1

)1)(1(11

)1(

1

)1)(1(

flowcashafter taxDiscounted

1

)1)(1(

1)1()1)(1(

)1()1)(1)((

eperspectivinvestorfromflowcashAfter tax

!

!

!

!

D

ECDEC

D

EC

DEC

DEC

t

tt

r

tkD

r

ttXDC

t

tt

tkDttX

tkDttkDXC

Equilibrium


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Equilibrium

If there is a positive discounted tax benefit firmschoose to borrow more, and investors withhigher personal tax rate on debt income isencouraged to enter the market. This implies areduction of tax benefits of borrowing.

Reverse effect is there is a negative discountedtax benefit of borrowing

In equilibrium, we expect the tax benefit fromborrowing to be equal to zero

This is the so-called Millers equilibriumdescribed in Appendix 14A in the textbook

Preferred stock


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Preferred stock

Preferred stock: dividends on preferred stock arenot tax deductible at the corporate level as areinterest payments on debt

This implies that corporate junior debt may be

tax efficient relative to preferred stock However, the US tax code allows a 70% tax

exclusion for preferred dividends paid tocorporate holders, so the yield on preferred

stock is often lower (before tax) than on juniordebt even though the debt has seniority over thepreferred stock

Investor conflicts?


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Investor conflicts?

Tax exempt equity holders prefer in general to reducethe borrowing of the firm so as to transfer income fromdebt repayments to dividend payments

High-tax bracket investor prefer the opposite

Often tax-exempt municipal bonds (or similarinvestments) offer yields that are greater than the aftertax yield on corporate bonds for high-tax bracketinvestors

Thus, the firm can give these investors an advantage by

increasing the firms borrowing, as this frees capital thatthe investors can use to invest in tax-exempt municipalbonds

Inflation


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Inflation

We expect to see a one-to-one relationshipbetween inflation and nominal interest rates - ifinflation increases by one percentage point thenso do nominal interest rates

Higher inflation, therefore, leads to highernominal borrowing costs that yield in turn greatertax deductions

Therefore, the tax effect has greater bite inperiods of high inflation

Empirical evidence


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Empirical evidence

Do firms with greater taxable earnings borrow more? No, but this may be because firms in general rarely issue equity

Firms that perform poorly, therefore, tend to accumulate debt tomeet their investments

Tax code changes that affect the relative tax benefit ofborrowing should have an impact on corporate financing Yes, US tax reform of 1986 which reduced the tax benefits of

other things than debt (such as depreciation rules andinvestment tax credits) gave rise to an increase in borrowingamong firms most affected

The firms less affected did not increase their borrowing to thesame extent

Taxes matter but dont explain everything

Readings


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Readings

Grinblatt/Titman chapter 14, including theappendix

14.10 Are There Tax Advantages to

Leasing not so relevant

Exercises


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Exercises

1. A firm has assets valued at 100, and debt valued at50. It plans to restructure its liability side by increasingits borrowing to 70 and paying a dividend of 20 to itsshareholders. The debt has zero beta before and0.001 beta after the recapitalization. The beta of the

equity is 2 before the recapitalization.a) What are the values of the equity before and after the

recapitalization?

b) What is the beta of the assets of the firm?

c) What is the beta of the equity after recapitalization?

d) The recapitalization has increased the beta of the debt (andtherefore the cost of debt capital). Has it also increased thebeta of the equity? Does this mean that the total cost offinancing has increased? Explain.

Week 8: Taxes and Dividends


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Week 8: Taxes and Dividends

In frictionless markets dividends dontmatter

Why do firms nonetheless pay dividends?

Taxes and dividends

Stock returns and dividend yields what isthe connection?

Investment distortions caused by taxes individends

Cash flow to shareholders


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Cash flow to shareholders

Shareholders earn money through holding equity thatearns a cash flow (such as dividends) and capital gains(which can be realized through selling stock)

The cash distribution to shareholders is normallydiscretional the company can decide how much cash

flow to give their shareholders Cash distribution comes in two forms dividend

payments and share repurchase schemes Dividend payments do not affect the number of shares

but will reduce the value of each share

Share repurchases do normally not affect the value ofeach share but will reduce the number of sharesoutstanding


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Dividend yields


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Dividend yields

Dividend yield is the ratio of dividends pershare over price per share

Typical pattern is that high-tech growth

firms have low dividend yield and dividendpayout ratios (Microsoft paid its very firstdividend this year)

Stable, old economy companies such as

mining, oil and manufacturing pay abouthalf their earnings as dividends

What is the optimal dividend payoutti ?


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ratio?

Assumption: frictionless economy (notransaction costs, taxes, or other frictions)

Investment policy unaffected by dividend

payments Modigliani-Miller Dividend Irrelevance

Theorem: The choice between paying dividends and

repurchasing shares is a matter ofindifference to shareholders

Modigliani-Miller Irrelevance


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Modigliani Miller Irrelevance

Consider two identical equity financedfirms, the only difference is dividend policy

Firm 1 pays 10m as dividends

Firm 2 repurchases stock worth 10m

After the end of the year, the firms areworth X

In the beginning each firm has 1m sharesoutstanding

MM cont


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MM cont

Each share eventually sells for X divided by the number of shares Firm 2 buys back 10m worth of stock If share price is p, and firm 2 buys back n shares, we know that

pn=10m We also know that p=X/(1m-n) Suppose X = 150m Solving both equations gives us n = (10m1m)/(X+10m), so we get n

= 62,500, and p = 150m/(1m-62,500) = 160 Firm 1: stock price is p = 150m/1m = 150, but each stock gives a

dividend worth 10m/1m = 10, so the total value of each stock is150+10 = 160

Since shareholders get the same cash flow eventually, the shares

must sell at the same price initially, i.e. dividend policy does notmatter

Taxes and cash distribution toh h ld


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shareholders Classical tax system

Dividends taxed as ordinary income and capital gains at a lowerrate than ordinary income

Dividends are not tax deductible at corporate level, so dividendsare also subject to corporate taxation

Imputation system Dividends are taxed as ordinary income but investors get a

partial tax credit for corporate taxes (to offset personal taxes)

Dividends are not tax deductible at corporate level

Systems that eliminate double taxation

Dividends are tax deductible at corporate level and taxed asordinary income at investor level

Classical tax system


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Classical tax system

The classical tax system implies a taxdisadvantage of dividend payments

Dividend $100, 35% tax implies an immediatetax liability of $35

Share repurchase scheme: an investor sells$100 worth of shares. Suppose original cost was$76. This implies a taxable capital gain of $24.Taxed at 20%, this implies an immediate taxliability of $4.8

Share repurchase scheme much cheaper thanpaying dividends

Tax avoidance schemes


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a a o da ce sc e es

In theory, investors can often invest in a schemethat gives an immediate tax relief against adeferred future tax liability

In practice, investors do not take advantage of

these schemes but instead choose to pay taxes(or are unable to invest in tax avoidanceschemes) on the received dividends

The question is, therefore, why corporations

continue to pay dividends when they are so taxinefficient

Dividend clienteles


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Some investors do not pay taxes These investors will, everything else being

equal, prefer high dividend yield firms to lowdividend yield firms as they do not pay tax on the

dividend Firms might adopt different dividend policies toattract different investor clienteles

Empirical evidence suggests that investorsportfolios have dividend yields that are related to

their tax status (high tax bracket investorschoose low dividend yield stocks and vice versa)

Dividend payments and stockreturns


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returns

Do stocks with high dividend yield compensateinvestors for the tax disadvantage?

Higher returns should then lead to lower values,

reflecting the higher discount rates applied tofuture cash flows

Research has focused on two returns effects

Ex-dividend day behaviour of stock prices

Whether cross-sectional dividend yield differencesaffect expected returns


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Ex-dividend day cont


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y

Transaction cost argument Consider buying a stock at $20 before the ex-div day, receive a $1

dividend, then sell the stock for $19.20. This yields $1 taxable profitsand $(20-19.20) = $0.80 tax deductible losses. The net profit is $0.20less taxes, but it is still arbitrage profits. The stock needs to drop by thefull amount to preclude arbitrage profits.

If there is a $0.10 per share transaction cost, the investor receives

taxable profits of $1 in dividends, and incur $0.80 in tax deductiblelosses. The net profit is $0.20, but the investor must also pay $0.10 intransaction costs, so the net profit is only $0.10 less taxes. If the stockdrops to $19.10, therefore, there are no arbitrage profits to be made.

If the dividend payment is only $0.40, the necessary price drop is $0.30to prevent arbitrage profits. That is, the price drop is greater for highdividend yielding stocks in percentage terms (as the clientele effect

predicts). Price drop less than the dividend payment is also observed incountries that do not have a classical tax system, suggesting this isnot a tax driven phenomenon at all

Cross-sectional relation betweendividend yield and stock returns


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dividend yield and stock returns

If dividends are more heavily taxed than capitalgains, the expected return must be greater forhigh dividend yield stocks.

Empirically, stocks with high dividend yields

have higher returns, but the relationship is notstraightforward

The relationship is U-shaped, with zero dividendyield stocks have higher expected return than

stocks with low dividend yield, but for stockspaying dividends, the expected return increaseswith the dividend yield

How dividend taxes affect financingand investment decisions


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and investment decisions Marginal tax rate of 50% Company has a choice between paying $1m in dividends or retain

the earnings Retained earnings yield 6% after corporate taxes (alternative II) Dividends yield 7% before personal taxes in corporate bonds

(alternative I)

Alternative I yields $500,000 to invest at 7%, which after tax yields$17,500 per year

Alternative II yields $60,000 in extra dividend payments per year,which yields $30,000 after tax to the investor

If you are a zero tax payer, however, alternative I yields $1,000,000to invest at 7%, which equals $70,000, and alternative II only

$60,000 in additional dividends per year. Investors with different tax rates are likely to disagree with regard to

the dividend policy the firm should pursue


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Readings


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g


Exercises


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1. A stock trades at 100p per share (prior to ex-dividendday) and the firm will pay a dividend of 10p per share.

a) Work out the ex-dividend day price if investors pay 40% tax ondividends and the ex-dividend day price equals the initial priceless after-tax dividend payment

b) Work out the minimum transaction cost per share thatprevents tax-arbitrage by a tax-paying investor

c) Suppose the dividend payment was 50p per share. What isyour answer to a) and b) now?

d) Suppose the actual transaction cost is 2p per share. What arethe arbitrage free price drops in a) and c) above now?

e) What are the implied tax rates on dividends in d)?

Week 9: Managerial Incentives andCorporate Finance


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Corporate Finance

Manager shareholder conflicts

Occidental Petroleum and founder/CEOArmand Hammer case in the textbook

Maxwell Communications and Robert Maxwell How such conflicts affect investment,

financing, and ownership structure

How such conflicts can be mitigated byexecutive compensation schemes

Separation of ownership andcontrol


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control

The separation of ownership and control is beneficial interms of diversification and optimal investment whilekeeping a stable management team in control of the firm

But it can be harmful if the management team is moreinterested in pursuing their own interest as opposed totheir shareholders interests

In what way do their interests differ? Managers represent investors, customers, suppliers, and

employees not just investors

Managers get utility from non-financial benefits such as status,perks, job-security etc and are willing to spend corporateresources on these even though they are likely to be negativeNPV projects

Factors that determine themanager shareholder conflict


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manager-shareholder conflict

Proportions of stock owned by the manager Managerial entrenchment and lack of means to

control managers Diffuse ownership structure (no individual manager

benefits enough to take action) Proxy fights (shareholder revolt at general meeting)

are very expensive and difficult to organize

Bonus schemes not performance sensitive

enough Changes in corporate governance have made

managers more accountable in recent years

Ownership structure


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Ownership structure is on the whole more concentrated than we wouldexpect (CAPM advocates diversification), particularly outside the US/UK Ownership concentration a response to weak legal protection of

shareholders interests UK/US have the strongest protection and the most diffuse ownership

structure

Managers tend to keep a significant ownership stake in firms where theincentive conflict with the shareholders is the greatest

In many internet IPOs, the managers kept a large share of their holding inorder to get a higher price in the IPO (lock in clauses)

Eg. Lastminute.com Martha Lane-Fox and Brent Hoberman (founders Hoberman still manager) were still large owners after IPO and wereprevented from selling their share for a given time period after the IPO

Firms with higher concentration of management ownership have highermarket values relative to their book values, provided management share isnot too big. If it gets above 5%, managers become entrenched whichallows them to pursue own interests more

How managers distort investmentdecisions


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decisions

Managers prefer investments that fit the managersexpertise Makes him (her) more indispensable

Investments in visible/fun industries Raising the managers external profile (and his potential future

job opportunities and wages) Investments that pay off early Financial success in the short run can increase bonus, reduce

the risk of losing job, increase the possibility of raising morecapital

Investments that reduce risk and increase the scope of

the firm To avoid bankruptcy the manager seeks relatively safe

investments and may take a portfolio approach to investments

Capital structure and managerialcontrol


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control

Managers are likely to prefer equity to debt because theyare interested in minimizing the probability of default

Shareholders may, therefore, prefer debt financing asdebt is a good way to discipline managers (the fear oflosing job is a good motivator)

Empirical investigations show there is a positiverelationship between leverage and Percentage of executive pay tied to performance Percentage of equity owned by managers Percentage of investment bankers on the board of directors Percentage of equity owned by large individual investors

Debt is a good way to curb overinvestment Debt engages often a bank who is a good monitor of

management

Executive compensation


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The problem of incentivizing managers is often called aprincipal-agent problem Tenant farmer works the land of a land-owner. If compensated

too much in terms of output, the tenant farmer must bear all therisk influencing output (weather etc). If compensated too little in

terms of output, the tenant farmer doesnt put in the requiredeffort.

Compensation is a matter of balancing the two concerns: Calledthe problem of designing the optimal incentive contract

Effort (input) cannot be observed, otherwise compensation couldbe tied to effort instead of output

Design objective is to minimize the agency costs of delegatedcontrol


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163/179

Readings


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Exercises


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1. The manager of a firm considers investing 1mof free cash flow (earnings currently held in abank account) in a project that has privatevalue 10,000 to the manager but NPV of -200,000 to the investors. What is the optimal

decision for the manager ifa) He has fixed pay?b) He has in addition a bonus scheme where an

increase of 1000 in the stock value leads to anincrease of 10 to the manager?

c) What is the optimal bonus scheme for the managerin this case?


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167/179

Distortions to managerial incentives


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Managers seek to maximize the share price The share price may, however, deviate from the intrinsic

value (the full information price)

Long term investors prefer that managers maximize theintrinsic value (which eventually transpires)

Short term investors prefer that managers maximize thecurrent share price (which may be distorted due to lackof information)

The conflict is, therefore, essentially one of short-termism versus long-termism


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170/179


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Dividends and Stock Repurchases:Announcement Effects


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Announcement Effects

An announcement of a dividend increase normallyincreases the stock price by about 2%

If a company announces it is to cut its dividendcompletely, the stock price decreases by about 9.5%

Is paying dividends therefore a good decision? Dividends may be a costly signal conveying information that is

hidden from investors

Paying dividends is, in effect, a cost to the shareholders toensure that current information is reflected in current prices

The alternative: long term savings in signalling costs against the

cost of deviations between the current stock price and theintrinsic value of equity

Dividends and InvestmentOpportunities


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Opportunities

News may be Increased cash flow

Increase in investment opportunities

An increase in dividends signals increased cash flow (asdividends then are more affordable) but is not consistent

with an increase in investment opportunities (as they arethen needed for investments)

An increase/cut in dividends is, therefore, a morecomplex signal than is suggested in previous slides

Empirical evidence suggests that cuts are viewed morefavourably when the firms experience an increase ininvestment opportunities


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Empirical Evidence


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Event study methodology Leverage increasing transactions (debt-for-equity swaps)

have positive stock price response

Leverage neutral transactions (debt-for-debt) have zeroresponse

Leverage decreasings (equity-for-debt) have negativestock price response

Security sales (equity, debt) have negative stock priceresponse, and more so for equity than for debt

Empirical evidence is consistent with informationtheories (this week) but is also consistent with incentivetheories (last week)

Adverse Selection


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Sick people tend to see health/life insurance as cheap consequently they will be over-represented in the groupof buyers of this type of insurance

Example: very expensive insurance that covers 100% ofall costs or cheap insurance that covers only 80% of

all costs In this case the sick people might migrate to the expensive type

of insurance and the healthy ones to the cheap type

This is called adverse selection buyers or sellers donot always select themselves randomly but rather

according to their type This also plays a role in the sale of corporate securities

Managers have inside knowledgeand at the same time sell or buy

t iti


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corporate securities Corporation can be expected to sell equity when

the stock is overvalued and buy back equitywhen the stock is undervalued

This makes sell transactions a bad signal andbuy transactions a good signal

This makes equity a bad source of capital fornew investment, since it must be sold at adiscount to the current stock price (why?)

Pecking-order theory: firms prefer retained

earnings to external capital, and external debt toexternal equity, when financing investments


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Exercise


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A firm has already made an investment and is considering anadditional investment opportunity State of nature is good or bad, equal probabilities. Assume risk neutral

valuation with zero discount rates. Manager knows the true state ofnature

Current investment has value 150 (good) or 50 (bad) NPV investment opportunity is 20 (good) or 10 (bad)

Currently the firm is financed by equity only It plans to issue equity to finance the new investment, which costs 100 To do:

Set up the balance sheet before and after investment @ expected values Work out how much of the existing equity the firm needs to sell in order to

finance the investment Compare the value of the existing (old) equity with investment and without

investment in the good and the bad state If the manager acts in the interests of the existing shareholders should he

AC210 Corporate Finance Lecture Notes_2

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