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MN20211: Corporate Finance 2012/13:
1. Revision: Investment Appraisal (NPV).
2. Investment flexibility, Decision trees, Real Options.
3. Revision: Portfolio Theory => CAPM
4. Capital Structure and Value of the Firm.
5. Optimal Capital Structure - Agency Costs, Signalling.
6. Dividend policy/repurchases.
7. Mergers and Acquisitions.
8. Venture Capital and Private Equity.
9. Introduction to Behavioural Finance/emotional finance.
10. Revision.
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Corporate Finance:
Three Major Decisions…
• Investment Appraisal (Capital Budgeting) – Which New Projects to invest in?
• Capital Structure (Financing Decision)- How
to Finance the new projects – Debt or equity?
• Payout Policy – Dividends, Share Repurchases, Re-
investment.
• => Objective: Maximisation of Shareholder Wealth.
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First Topic: Investment Appraisal
• Brief revision of static NPV.
• => Flexibility
• => Decision trees
• => sensitivity analysis
• => Real Options
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Investment Appraisal.
• Objective: Take projects that increase
shareholder wealth (Value-adding projects).
• Investment Appraisal Techniques: NPV,
IRR, Payback, ARR, Real Options….
• Which one is the Best rule for shareholder
wealth maximisation?
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•
•
Connections in Corporate Finance.
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/APT.
Capital Structure and effect on Firm Value and WACC.
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• 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
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•
Net Present Value
• .....)1()1(1 3
3
2
21
r
X
r
X
r
XINPV
r
XINPV Perpetuities.
IRR =>
Take Project if NPV > 0, or if IRR > r.
.0.....)1()1(1 3
3
2
21
IRR
X
IRR
X
IRR
XINPV
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•
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 £200k PA.
- A feasibility study, cost £5000, has already been
carried out.
Discount Rate equals 12%.
Should we take the project?
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•
$000 2012 2013 2014 2015 2016 2017
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 0
DO WE INVEST IN THIS NEW PROJECT?
NPV > 0.
COST OF CAPITAL (12%) < IRR (19.75%).
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•
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
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•
CONFLICT BETWEEN APPRAISAL TECHNIQUES. YEAR A B C D DF: 10%
0 -1000 -1000 -1000 -1000 1
1 100 0 100 200 0.909
2 900 0 200 300 0.826
3 100 300 300 500 0.751
4 -100 700 400 500 0.683
5 -400 1300 1250 600 0.621
PAYBACK METHOD:
PROJECT A: 2 YEARS SELECT PROJECT A
PROJECT B: 4 YEARS
PROJECT C: 4 YEARS
PROJECT D: 3 YEARS
NPV:
PROJECT A: -407
PROJECT B: 511
PROJECT C: 531 SELECT PROJECT C
PROJECT D: 519
IRR
PROJECT A: -200%
PROJECT B: 20.9%
PROJECT C: 22.8%
PROJECT D: 25.4% SELECT PROJECT D
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•
NPV
Discount Rate 10% 22.8%
PROJ C
531
PROJ D
519
25.4%
COMPARING NPV AND IRR - 1
Select Project with higher NPV: Project C.
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•
NPV
Discount Rate
COMPARING NPV AND IRR -2
Impossible to find IRR!!! NPV exists!
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• COMPARING NPV AND IRR –3 Size Effect
• 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?
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• Mutually Exclusive project: firm can only
take one (take project with highest positive
NPV).
Independent project: firm can take as many as
it likes (take all positive NPV projects).
Consider slide 10: Which project(s) would you
take, and what would be the value-added, if
projects are a) mutually exclusive, and b)
independent?
Mutually Exclusive Versus
Independent Projects.
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Investment Flexibility/ Real options.
• Reminder of Corporation’s Objective : Take projects that increase shareholder wealth (Value-adding projects).
• Investment Appraisal Techniques: NPV, IRR, Payback, ARR
• Decision trees
• Monte Carlo.
• Real Options
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Investment Flexibility, Decision Trees, and Real
Options
Decision Trees and Sensitivity Analysis.
•Example: From Ross, Westerfield and Jaffe: “Corporate Finance”.
•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.
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$000 Year 1 Year 2 - 6
Revenues 6000
Variable Costs -3000
Fixed Costs -1791
Depreciation -300
Pretax Profit 909
Tax (34%) -309
Net Profit 600
Cashflow 900
Initial Investment -1500
Date 1 NPV = -1500 +
5
1 )15.1(
900
tt
= 1517
Production Stage: Base Case
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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
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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).
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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 8154
Market Share -696 1517 5942
Price 853 1517 2844
Variable Cost 189 1517 2844
Fixed Cost 1295 1517 1628
Investment 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.
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Real Options
• A new investment appraisal method,
analysed by academics in the 1980s
• Existing NPV method: static: one-off
decision to take project or ‘throw it away’:
once project is taken, committed to it.
• Real Options: recognises flexibility in
decision-making.
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Real Options.
A digression: Financial Options
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.
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Example:
• Today, you buy a call option on Marks and
Spencer’s shares. The call option gives you the
right (but not the obligation) to buy MS shares at
exercise date (say 31/12/10) at an exercise price
given now (say £10).
• At 31/12/10: MS share price becomes £12. Buy at
£10: immediately sell at £12: profit £2.
• Or: MS shares become £8 at 31/12/10: rip option
up!
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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.
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Options: Payoff Profiles.
Buying a Call Option.
S
W
Selling a put option.
Selling a Call Option. Buying a Put Option.
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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.
c
q
1- q
Cu = 3
Cd=0
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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.
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Alternative option-pricing method
• Black-Scholes
• Continuous Distribution of share returns
(not binomial)
• Continuous time (rather than discrete time).
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Real Options
• Just as financial options give the investor the right (but not obligation) to future share investment (flexibility)
• Researchers recognised that investing in projects can be considered as ‘options’ (flexibility).
• “Real Options”: Option to delay, option to expand, option to abandon.
• Real options: dynamic approach (in contrast to static NPV).
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Real Options
• Based on the insights, methods and
valuation of financial options which give
you the right to invest in shares at a later
date
• RO: development of NPV to recognise
corporation’s flexibility in investing in
PROJECTS.
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Real Options.
• Real Options recognise flexibility in
investment appraisal decision.
• Standard NPV: static; “now or never”.
• Real Option Approach: “Now or Later”.
• -Option to delay, option to expand, option
to abandon.
• Analogy with financial options.
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Types of Real Option
• Option to Delay (Timing Option).
• Option to Expand (eg R and D).
• Option to Abandon.
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Option to Delay (= call option)
•
Project
value
Value-
creation
Investment in
waiting:
(sunk)
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Option to expand (= call option)
•
Project
value
Value creation
Investment in
initial project:
eg R and D
(sunk)
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Option to Abandon ( = put option)
•
Project
value
Project goes
badly: abandon
for liquidation
value.
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Valuation of Real Options
• Binomial Pricing Model
• Black-Scholes formula
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Value of a Real Option
• A Project’s Value-added = Standard NPV
plus the Real Option Value.
• For given cashflows, standard NPV
decreases with risk (why?).
• But Real Option Value increases with risk.
• R and D very risky: => Real Option element
may be high.
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•
Simplified Examples
• Option to Expand (page 241 of RWJ)
Build First Ice
Hotel
If Successful
Expand
If unsuccessful
Do not Expand
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• NPV of single ice hotel
• NPV = - 12,000,000 + 2,000,000/0.20 =-2m
• Reject?
• Optimistic forecast: NPV = - 12M + 3M/0.2
• = 3M.
• Pessimistic: NPV = -12M + 1M/0.2 = - 7m
• Still reject?
Option to Expand (Continued)
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Option to expand (continued)
• Given success, the E will expand to 10
hotels
• =>
• NPV = 50% x 10 x 3m + 50% x (-7m) =
11.5 m.
• Therefore, invest.
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Option to abandon.
• NPV(opt) = - 12m + 6m/0.2 = 18m.
• NPV (pess) = -12m – 2m/0.2 = -22m.
• => NPV = - 2m. Reject?
• But abandon if failure =>
• NPV = 50% x 18m + 50% x -12m/1.20
• = 2.17m
• Accept.
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Option to delay and Competition (Smit and Ankum).
•-Smit and Ankum present a binomial real option model:
•Option to delay increases value (wait to observe market demand)
•But delay invites product market competition: reduces value (lost
monopoly advantage).
•cost: Lost cash flows
•Trade-off: when to exercise real option (ie when to delay and
when to invest in project).
•Protecting Economic Rent: Innovation, barriers to entry,
product differentiation, patents.
•Firm needs too identify extent of competitive advantage.
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Option to delay versus competition:
Game-theoretic approach
Firm 1\Firm 2 Invest early Delay
Invest early NPV = 500,NPV = 500 NPV = 700, NPV = 300
Delay NPV = 300, NPV = 700
NPV = 600,NPV = 600
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Option to delay versus competition:
effects of legal system
Firm 1\ Firm 2 Invest early Delay
Invest early NPV = 500,NPV = 500 NPV = 700- 300, NPV =
300+300
Delay NPV = 300+300, NPV =
700-300
NPV = 600,NPV = 600
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Monte Carlo methods
• BBQ grills example in RWJ.
• Application to Qinetiq (article by Tony
Bishop).
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Use of Real Options in Practice
•
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• . •
SECTION 2: Risk and Return/Portfolio Decision/
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
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.
• .
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
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• •
Risk Aversion.
Investors prefer more certain returns to less certain returns.
Wealth
U
150 100
200
Risk Averse Investor prefers £150 for sure than a 50/50
gamble giving £100 or £200.
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• Portfolio Analysis.
Two Assets: Investor has proportion a of Asset X and (1-a) of
Asset Y.
).()1()(.)( YXp REaREaRE
).,().1(2)(.)1()(.)( 22 yxCovaaYVaraXVaraRVar p
Combining the two assets in differing proportions.
E(R)
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• 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
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• 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.
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Relationship between Investor Portfolio
Decision and Firm’s Cost of Capital
• Investors can diversify away all specific risk;
therefore, should only be rewarded for holding
each firm’s market risk => CAPM.
• CAPM provides the firm’s cost of equity.
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•
].)([)( fmfi rrErrE
)(rE
fr
1
)( mrE
Security Market Line.
.2
m
im
Capital Asset Pricing Model
•
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•
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
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• • 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 in NPV of new
investments.
ed KequityKdebtWACC *%*%
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Lecture 5 and 6: Capital Structure and Dividends.
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 oB
IVE n 0
New Firm Value
Original equity holders
New equity
nVV
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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.
20
Value of Debt
Original Equity
New Equity
Total Firm Value
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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
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Value of the Firm and Capital Structure
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).
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Value of the Firm = discounted value of future cashflows available to
the providers of capital.
-Assume Incomes are perpetuities.
Miller- Modigliani Theorem:
.)1(
.
)1(
DEDUL
EU
VVWACC
TNCFVTVV
VTNCF
V
Irrelevance Theorem: Without Tax, Firm Value is
independent of the Capital Structure.
Note that
ed KequitytKdebtWACC *%)1(*%
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K
D/E
K
D/E
V
D/E D/E
V
Without Taxes With Taxes Ke
WACC
Kd rf
Kd(1-t)
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See Example
• Firm X
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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
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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.
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Combining Tax Relief and Debt Capacity (Traditional View).
D/E D/E
V
K
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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.
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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
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Jensen and Meckling (1976)
B
V
V*
V1
B1
A
If manager owns all of the equity, equilibrium point A.
Slope = -1
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B
V
Jensen and Meckling (1976)
V*
V1
B1
A B
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
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B
V
Jensen and Meckling (1976)
V*
V1
B1
A B
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 B2.
V2
B2
Slope = -1
Slope = -1/2
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Jensen and Meckling - Numerical Example.
PROJECT PROJECT
A B
EXPECTED INCOME 500 1000
MANAGER'S SHARE:
100% 500 1000
VALUE OF PRIVATE 800 500
BENEFITS
TOTAL WEALTH 1300 1500
MANAGER'S SHARE:
50% 250 500
VALUE OF PRIVATE 800 500
BENEFITS
TOTAL WEALTH 1050 1000
Manager issues
100% Debt.
Chooses Project B.
Manager issues
some Debt and
Equity.
Chooses Project A.
Optimal Solution: Issue Debt?
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Issuing debt increases the manager’s fractional
ownership => Firm value rises.
-But:
Debt and risk-shifting.
State 1 100 0 0.5
State 2 100 170 0.5
100 85
Values: Debt 50 25
Equity 50 60
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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*
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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).
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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)?
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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.
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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.
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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.
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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.
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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?
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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.
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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.”
Page 85
85
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.
Page 86
86
Myers-Majluf (1984).
-managers know the true future cashflow.
They act in the interest of initial shareholders. P = 0.5 Do
Nothing:
Good Bad
Issue
Equity
Good Bad
Assets
in Place250 130 350 230
NPV of
new
project
0 0 20 10
Value of
Firm250 130 370 240
Expected Value 190 305
New investors 0 100
Old Investors 190 205
Page 87
87
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
Page 88
88
Do
nothing
Issue
and
invest
Good
News
250 * 248.69
Bad
News
130 161.31*
Old Shareholders’ payoffs Equilibrium
Do
nothing
Issue
and
invest
Good
News
250 * 248.69
Bad
News
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.
Page 89
89
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.
Page 90
90
Practical Methods employed by Companies (See
Damodaran; Campbell and Harvey).
-Trade off models: PV of debt and equity.
-Pecking order.
-Benchmarking.
-Life Cycle.
time
Increasing Debt?
Page 91
91
Trade-off Versus Pecking Order.
• Empirical Tests.
• Multiple Regression analysis (firm size/growth
opportunities/tangibility of assets/profitability…..
• => Relationship between profitability and leverage
(debt): positive => trade-off.
• Or negative => Pecking order:
• Why?
• China: Reverse Pecking order
Page 92
92
Capital Structure and Product
Market Competition.
• Research has recognised that firms’ financial decisions and product market decisions not made in isolation.
• How does competition in the product market affect firms’ debt/equity decisions?
• Limited liability models: Debt softens competition: higher comp => higher debt.
• Predation models: higher competition leads to lower debt. (Why?)
Page 93
93
Capital Structure and Takeovers
• Garvey and Hanka:
• Waves of takeovers in US in 1980’s/1990’s.
• Increase in hostile takeovers => increase in
debt as a defensive mechanism.
• Decrease in hostile takeovers => decrease in
debt as a defensive mechanism.
Page 94
94
Garvey and Hanka (contiuned)
•
D/E
D/E*
V Trade-off: Tax shields/effort
levels/FCF/ efficiency/signalling
Vs financial distress
Page 95
95
Practical Capital Structure: case
study
•
Page 96
96
Lecture 6: Dividend Policy
• Miller-Modigliani Irrelevance.
• Gordon Growth (trade-off).
• Signalling Models.
• Agency Models.
• Lintner Smoothing.
• Dividends versus share repurchases.
• Empirical examples
Page 97
97
Early Approach.
• Three Schools of Thought-
• Dividends are irrelevant (MM).
• Dividends => increase in stock prices
(signalling/agency problems).
• Dividends => decrease in Stock Prices (negative
signal: non +ve NPV projects left?).
• 2 major hypotheses: Free-cash flow versus
signalling
Page 98
98
Important terminology
• Cum Div: Share price just before dividend
is paid.
• Ex div: share price after dividend is paid <
Cum div.
P
Time
CD
ED
CD
ED
CD
ED
Page 99
99
Example
• A firm is expecting to provide dividends every year-end forever of £10. The cost of equity is 10%.
• We are at year-end, and div is about to be paid. Current market value of equity = 10/0.1 + 10 = £110
• Div is paid. Now, current market value is
• V = 10/0.1 = £100.
• So on…
Page 100
100
•
P
Time
CD =
110
ED = 100
CD
ED
CD
ED
Page 101
101
Common Stock Valuation Model
• You are considering buying a share at price Po,
and expect to hold it one year before selling it
ex-dividend at price P1: cost of equity = r.
)1()1(
110
r
P
r
dP
What would the buyer be prepared to pay to you?
)1()1(
221
r
P
r
dP
Page 102
102
2
2
2
210
)1()1(1 r
p
r
d
r
dP
Therefore:
Continuing this process, and re-substituting in
(try it!), we obtain:
1
10
)1(t tr
dp
Price today is discounted value of all future dividends to
infinity (fundamental value = market value).
Page 103
103
Dividend Irrelevance (Miller-
Modigliani)
• MM consider conditions under which dividends are irrelevant.
• Investors care about both dividends and capital gains.
• Perfect capital markets:-
• No distorting taxes
• No transactions costs.
• No agency costs or assymetric info.
Page 104
104
Dividend Irrelevance (MM):
continued
• Intuition: Investors care about total return
(dividends plus capital gains).
• Homemade leverage argument
• Source and application of funds argument
=> MM assumed an optimal investment
schedule over time (ie firm invests in all
+ve NPV projects each year).
Page 105
105
Deriving MM’s dividend irrelevance
• Total market value of our all-equity firm is
•
T
t t
t
r
DS
10)1(
Sources = Uses
1)1( ttttt FrIDFCF
Page 106
106
Re-arranging:
1)1( ttttt FrIFCFD
T
tr
FrIFCFFrIFCFS
2
011110000 ...
)1(
)1()1(
010 FCF
Substitute into first equation:
At t =0,
T
tr
FrIFCFIFS
2
0111000 ...
)1(
)1(
Page 107
107
Successive substitutions
T
tt
tt
r
ICFS
00)1(
)(
•Current value of all-equity firm is present value of operating
cashflows less re-investment for all the years (residual
cashflow available to shareholders) Dividends do not appear!
•Assn: firms make optimal investments each period (firm
invests in all +ve NPV projects).
•Firms ‘balance’ divs and equity each period: divs higher
than residual cashflow => issue shares.
•Divs lower than free cashflow: repurchase shares.
Page 108
108
Irrelevance of MM irrelevance
(Deangelo and Deangelo)
• MM irrelevance based on the idea that all
cash will be paid as dividend in the end (at
time T).
• Deangelo argues that even under PCM, MM
irrelevance can break down if firm never
pays dividend!
Page 109
109
Irrelevance of MM irrelevance
(continued) • Consider an all-equity firm that is expected to produce
residual cashflows of £10 per year for 5 years.
• Cost of equity 10%.
• First scenario: firm pays no dividends for the first 4 years.
Pays all of the cashflows as dividends in year 5.
• Now it is expected to pay none of the cashflows in any year:
Vo = 0 !
?)1.1(
105
10 t tV
Page 110
110
“Breaking” MM’s Irrelevance
• MM dividend irrelevance theorem based on:
• PCM
• No taxes
• No transaction costs
• No agency or asymmetric information
problems.
Page 111
111
Gordon Growth Model.
• MM assumed firms made optimal investments out
of current cashflows each year
• Pay any divs it likes/ balanced with new
equity/repurchases.
• What if information problems etc prevent firms
easliy going back to capital markets:
• Now, real trade-off between investment and
dividends?
Page 112
112
Gordon Growth Model.
Where does growth come from?- retaining
cashflow to re-invest.
.)1)(1(001
0Kr
KKrNCF
g
Div
g
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.
Page 113
113
Example of Gordon Growth Model.
£K 19x5 19x6 19x7 19x8 19x9 Average
Profits After Tax (NCF) 2500 2760 2635 2900 3100
Retained Profit (NCF.K) 1550 1775 1600 1800 1900
Dividend (NCF(1-K)) 950 985 1035 1100 1200
Share Capital + retentions
B/F 30000 31550 33325 34925 36725
C/F (= BF + Retained Profit) 31550 33325 34925 36725 38625
Retention Rate K 0.62 0.64 0.61 0.62 0.61 0.62
r 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?
Page 114
114
Gordon Growth Model (Infinite Constant
Growth Model).
Let %12
05.012.0
1260)05.1(1200)1( 100
gg
Div
g
gDivV
= 18000
Page 115
115
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 = .
Page 116
116
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
Page 117
117
Dividend Smoothing V optimal
re-investment (Fairchild 2003)
• Method:-
• GG Model: derive optimal retention/payout ratio
• => deterministic time path for dividends, Net income, firm values.
• => Stochastic time path for net income: how can we smooth dividends (see Lintner smoothing later….)
Page 118
118
Deterministic Dividend Policy.
• Recall
•
• Solving
• We obtain optimal retention ratio
•
.)1)(1(01
0Kr
KrKN
g
DivV
,00
K
V
.)1)((
*r
rK
Page 119
119
Analysis of
• If
• If with
• Constant r over time => Constant K* over
time.
*K
],1
,0[
r .0*K
],1
,0[
r ],1,0[*K .0
*
r
K
Page 120
120
Deterministic Case (Continued).
• Recursive solution:
• => signalling equilibria.
• Shorter horizon => higher dividends.
t
t rKKND )*1*)(1(0
When r is constant over time, K* is constant. Net
Income, Dividends, and firm value evolve
deterministically.
Page 121
121
Stochastic dividend policy.
• Future returns on equity normally and
independently distributed, mean r.
• Each period, K* is as given previously.
• Dividends volatile.
• But signalling concerns: smooth dividends.
• => “buffer” from retained earnings.
Page 122
122
Agency problems
• Conflicts between shareholders and
debtholders: risk-shifting: high versus low
dividends => high divs => credit rating of
debt
• Conflicts between managers and
shareholders: Jensen’s FCF, Easterbrook.
Page 123
123
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.
C. 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.
Page 124
124
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 0 800 400
New 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).
Page 125
125
Dividend Signalling Models.
• Bhattacharya (1979)
• John and Williams (1985)
• Miller and Rock (1985)
• Ofer and Thakor (1987)
• Fuller and Thakor (2002).
• Fairchild (2010).
• Divs credible costly signals: Taxes or borrowing costs.
Page 126
126
Competing Hypotheses.
• Dividend Signalling hypothesis Versus Free Cashflow hypothesis.
• Fuller and Thakor (2002; 2008): Consider asymmetric info model of 3 firms (good, medium, bad) that have negative NPV project available
• Divs used as a) a positive signal of income, and b) a commitment not to take –ve NPV project (Jensen’s FCF argument).
• Both signals in the same direction (both +ve)
Page 127
127
Signalling, FCF, and Dividends. Fuller and Thakor (2002)
• Signalling Versus FCF hypotheses.
• Both say high dividends => high firm value
• FT derive a non-monotonic relationship
between firm quality and dividends.
Firm
Quality
Divs
Page 128
128
Fairchild (2009, 2010)
• Signalling Versus FCF hypotheses.
• But, in contrast to Fuller and Thakor, I
consider +ve NPV project.
• Real conflict between high divs to signal
current income, and low divs to take new
project.
• Communication to market/reputation.
Page 129
129
Cohen and Yagil
• New agency cost: firms refusing to cut
dividends to invest in +ve NPV projects.
• Wooldridge and Ghosh
• 6 roundtable discussions of CF.
Page 130
130
Agency Models.
• Jensen’s Free Cash Flow (1986).
• Stultz’s Free Cash Flow Model (1990).
• Easterbrook.
• Fairchild (2009/10): Signalling + moral
hazard.
Page 131
131
Behavioural Explanation for
dividends
• Self-control.
• Investors more disciplined with dividend
income than capital gains.
• Mental accounting.
• Case study from Shefrin.
• Boyesen case study.
Page 132
132
D. 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 C
K 0.5 0 1
YEAR EPS DIV DIV DIV
1 30.00 13.25 11.50 15.00
2 34.00 15.13 11.50 17.00
3 28.00 14.56 11.50 14.00
4 25.00 13.53 11.50 12.50
5 29.00 14.02 11.50 14.50
6 33.00 15.26 11.50 16.50
7 36.00 16.63 11.50 18.00
8 40.00 18.31 11.50 20.00
Page 133
133
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).
Page 134
134
Dividends and earnings.
• Relationship between dividends, past,
current and future earnings.
• Regression analysis/categorical analysis.
Page 135
135
Dividends V Share Repurchases.
• Both are payout methods.
• If both provide similar signals, mkt reaction
should be same.
• => mgrs should be indifferent between
dividends and repurchases.
Page 136
136
Dividend/share repurchase
irrelevance
• Misconception (among practitioners) that
share repurchasing can ‘create’ value by
spreading earnings over fewer shares
(Kennon).
• Impossible in perfect world:
• Fairchild (JAF).
Page 137
137
Dividend/share repurchase
irrelevance (continued)
• Fairchild: JAF (2006):
• => popular practitioner’s website argues
share repurchases can create value for non-
tendering shareholders.
• Basic argument: existing cashflows/assets
spread over fewer shares => P !!!
• Financial Alchemy !!!
Page 138
138
The Example:….
• Kennon (2005): Eggshell Candies Inc
• Mkt value of equity = $5,000,000.
• 100, 000 shares outstanding
• => Price per share = $50.
• Profit this year = £1,000,000.
• Mgt upset: same amount of candy sold this
year as last: growth rate 0% !!!
Page 139
139
Eggshell example (continued)
• Executives want to do something to make
shareholders money after the disappointing
operating performance:
• => One suggests a share buyback.
• The others immediately agree !
• Company will use this year’s £1,000,000
profit to but stock in itself.
Page 140
140
Eggshell example (continued)
• $1m dollars used to buy 20,000 shares (at $50 per share). Shares destroyed.
• => 80,000 shares remain.
• Kennon argues that, instead of each share being 0.001% (1/100,000) of the firm, it is now .00125% of the company (1/80)
• You wake up to find that P from $50 to $62.50. Magic!
Page 141
141
Kennon quote
• “When a company reduces the amount of
shares outstanding, each of your shares
becomes more valuable and represents a
greater % of equity in the company … It is
possible that someday there may be only 5
shares of the company, each worth one
million dollars.”
• Fallacy! CF: no such thing as a free lunch!
Page 142
142
MM Irrelevance applied to Eggshell
example
g
gNV
)1(00
At beginning of date 0:
At end of date 0, with N0 just achieved, but still in the
business (not yet paid out as dividends or repurchases:
g
gNNV
)1(100
Page 143
143
Eggshell figures
25.0
000,000,5000,000,1
000,000,1)1(1
00
g
gNNV
Cost of equity will not change: only way to increase value
per share is to improve company’s operating performance, or
invest in new positive NPV project. Repurchasing shares is a
zero NPV proposition (in a PCM).
Eggshell has to use the $1,000,000 profit to but the shares.
Page 144
144
Eggshell irrelevance (continued)
• Assume company has a new one-year zero
NPV project available at the end of date 0.
• 1. Use the profit to Invest in the project.
• 2. Use the profit to pay dividends, or:
• 3. Use the profit to repurchase shares.
Page 145
145
Eggshell (continued)
50$000,000,525.0
000,000,1000,000,10 PV
40$000,000,425.0
000,000,10 PV Ex div
50$000,000,425.0
000,000,10 PV
Each year –end: cum div = $50, ex div = $40
1.
2.
3.
Page 146
146
Long-term effects of repurchase
• See tables in paper:
• Share value pre-repurchase = $5,000,000 each
year.
• Share value-post repurchase each year =
$4,000,000
• Since number of shares reducing, P .by 25%, but
this equals cost of equity.
• And is same as investing in zero NPV project.
Page 147
147
Conclusion of analysis
• In PCM, share repurchasing cannot increase share price (above a zero NPV investment) by merely spreading cashflows over smaller number of shares.
• Further, if passing up positive NPV to repurchase, not optimal!
• Asymmetric info: repurchases => positive signals.
• Agency problems: FCF.
• Market timing.
• Capital structure motives.
Page 148
148
Dividend/share repurchase
irrelevance
• See Fairchild (JAF 2005)
• Kennon’s website
Page 149
149
Evidence.
• Mgrs think divs reveal more info than repurchases (see Graham and Harvey “Payout policy”.
• Mgrs smooth dividends/repurchases are volatile.
• Dividends paid out of permanent cashflow/repurchases out of temporary cashflow.
Page 150
150
Motives for repurchases
(Wansley et al, FM: 1989).
• Dividend substitution hypothesis.
• Tax motives.
• Capital structure motives.
• Free cash flow hypothesis.
• Signalling/price support.
• Timing.
• Catering.
Page 151
151
Repurchase signalling.
• Price Support hypothesis: Repurchases
signal undervaluation (as in dividends).
• But do repurchases provide the same signals
as dividends?
Page 152
152
Repurchase signalling:
(Chowdhury and Nanda Model: RFS 1994)
• Free-cash flow => distribution as
commitment.
• Dividends have tax disadvantage.
• Repurchases lead to large price increase.
• So, firms use repurchases only when
sufficient undervaluation.
Page 153
153
Open market Stock Repurchase
Signalling: McNally, 1999
• Signalling Model of OM repurchases.
• Effect on insiders’ utility.
• If do not repurchase, RA insiders exposed
to more risk.
• => Repurchase signals:
• a) Higher earnings and higher risk,
• b) Higher equity stake => higher earnings.
Page 154
154
Repurchase Signalling : Isagawa FR 2000
• Asymmetric information over mgr’s private
benefits.
• Repurchase announcement reveals this info
when project is –ve NPV.
• Repurchase announcement is a credible
signal, even though not a commitment.
Page 155
155
Costless Versus Costly Signalling: Bhattacharya and Dittmar 2003
• Repurchase announcement is not commitment.
• Costly signal: Actual repurchase: separation of good and bad firm.
• Costless (cheap-talk): Announcement without repurchasing. Draws analysts’ attention.
• Only good firm will want this
Page 156
156
Repurchase timing
• Evidence: repurchase timing (buying shares
cheaply.
• But market must be inefficient, or investors
irrational.
• Isagawa.
• Fairchild and Zhang.
Page 157
157
Repurchases and irrational
investors. Isagawa 2002
• Timing (wealth-transfer) model.
• Unable to time market in efficient market with rational investors.
• Assumes irrational investors => market does not fully react.
• Incentive to time market.
• Predicts long-run abnormal returns post-announcement.
Page 158
158
Repurchase Catering.
• Baker and Wurgler: dividend catering
• Fairchild and Zhang: dividend/repurchase
catering, or re-investment in positive NPV
project.
Page 159
159
Competing Frictions Model: From Lease et al:
•
Asymmetric
Information
Agency
Costs
High
Payout
Low
Payout
Taxes
High
Payout
Low Payout
High Payout Low Payout
Page 160
160
Dividend Cuts bad news?
• Fairchild’s 2009/10 article.
• Wooldridge and Ghosh:=>
• ITT/ Gould
• Right way and wrong way to cut dividends.
• Other cases from Fairchild’s article.
• Signalling/FCF hypothesis.
• FCF: agency cost: cutting div to take –ve NPV project.
• New agency cost: Project foregone to pay high dividends.
• Communication/reputation important!!
Page 161
161
Lecture 9: Venture Capital/private
equity
• Venture capitalists typically supply start-up
finance for new entrepreneurs.
• VC’s objective; help to develop the venture over 5
– 7 years, take the firm to IPO, and make large
capital gains on their investment.
• In contrast, private equity firms invest in later
stage public companies to take them private….
Page 162
162
Private Equity.
• PE firms generally buy poorly performing publically listed firms.
• Take them private
• Improve them (turn them around).
• Hope to float them again for large gains
• Our main focus in this course is venture capital, But will look briefly at PE later.
• “Theory of private equity turnarounds” plus PE leverage article, plus economics of PE articles.
Page 163
163
Venture capitalists
• Venture capitalists provide finance to start-up entrepreneurs
• New, innovative, risky, no track-record…
• Hence, these Es have difficulty obtaining finance from banks or stock market
• VCs more than just investors
• Provide ‘value-adding’ services/effort
• Double-sided moral hazard
Page 164
164
Venture capital process
• Investment appraisal stage: seeking out good entrepreneurs/business plans: VC overconfidence?
• Financial contracting stage: negotiate over cashflow rights and control rights.
• Performance stage: both E and VC exert value-adding effort: double-sided moral hazard.
• Ex post hold-up/renegotiation stage? Double sided moral hazard
• => exit: IPO/trade sale => capital gains (IRR)
Page 165
165
VC process (continued)
• VCs invest for 5-7 years.
• VCs invest in a portfolio of companies:
anticipate that some will be highly
successful, some will not
• => attention model of Gifford.
Page 166
166
C. Venture Capital Financing
• Active Value-adding Investors.
• Double-sided Moral Hazard problem.
• Asymmetric Information.
• Negotiations over Cashflows and Control
Rights.
• Staged Financing
• Remarkable variation in contracts.
Page 167
167
Features of VC financing.
• Bargain with mgrs over financial contract
(cash flow rights and control rights)
• VC’s active investors: provide value-added
services.
• Reputation (VCs are repeat players).
• Double-sided moral hazard.
• Double-sided adverse selection.
Page 168
168
Kaplan and Stromberg
• Empirical analysis, related to financial
contract theories.
Page 169
169
Financial Contracts.
• Debt and equity.
• Extensive use of Convertibles.
• Staged Financing.
• Control rights (eg board control/voting
rights).
• Exit strategies well-defined.
Page 170
170
Fairchild (2004)
• Analyses effects of bargaining power,
reputation, exit strategies and value-adding
on financial contract and performance.
• 1 mgr and 2 types of VC.
• Success Probability depends on effort:
VCiM eeP
},1,0{iwhere => VC’s value-
adding.
Page 171
171
Fairchild’s (2004) Timeline
• Date 0: Bidding Game: VC’s bid to supply finance.
• Date 1: Bargaining game: VC/E bargain over financial contract (equity stakes).
• Date 2: Investment/effort level stage.
• Date 3: Renegotiation stage: hold-up problems
• Date 4: Payoffs occur.
Page 172
172
Bargaining stage
• Ex ante Project Value
• Payoffs:
.0).1( PRPPRV
.2
2
mM
ePRS
.2
)1(
2
VCVC
ePRS
Page 173
173
Optimal effort levels for given
equity stake:
•
,*
me
.)1(
*
VCe
Page 174
174
Optimal equity proposals.
• Found by substituting optimal efforts into
payoffs and maximising.
• Depends on relative bargaining power,
VC’s value-adding ability, and reputation
effect.
• Eg; E may take all of the equity.
• VC may take half of the equity.
Page 175
175
Equity Stake
Payoffs
E
VC
0.5
Page 176
176
E’s choice of VC or angel-financing
• Explain Angels.
• Complementary efforts
• Ex post hold-up/stealing threat
• Fairchild’s model
Page 177
177
To come
• Legal effects: (Fairchild and Yiyuan)
• => Allen and Song
• => Botazzi et al
• Negative reciprocity/retaliation.
Page 178
178
Ex post hold-up threat
• VC power increases with time.
• Exit threat (moral hazard).
• Weakens entrepreneur incentives.
• Contractual commitment not to exit early.
• => put options.
Page 179
179
Other Papers
• Casamatta: Joint effort: VC supplies
investment and value-adding effort.
• Repullo and Suarez: Joint efforts: staged
financing.
• Bascha: Joint efforts: use of convertibles:
increased managerial incentives.
Page 180
180
Complementary efforts (Repullo and
Suarez).
• Lecture slides to follow…
Page 181
181
Control Rights.
• Gebhardt.
• Lecture slides to follow
Page 182
182
Asymmetric Information
• Houben.
• PCP paper.
• Tykvova (lock-in at IPO to signal quality).
Page 183
183
E’s choice of financier
• VC or bank finance (Ueda, Bettignies and
Brander).
• VC or Angel (Chemmanur and Chen,
Fairchild).
Page 184
184
Fairness Norms and Self-interest in VC/E
Contracting: A Behavioral Game-theoretic
Approach
• Existing VC/E Financial Contracting Models assume narrow self-interest.
• Double-sided Agency problems (both E and VC exert Value-adding Effort) (Casamatta JF 2003, Repullo and Suarez 2004, Fairchild JFR 2004).
• Procedural Justice Theory: Fairness and Trust important.
• No existing behavioral Game theoretic models of VC/E contracting.
Page 185
185
My Model:
• VC/E Financial Contracting, combining
double-sided Moral Hazard (VC and E
shirking incentives) and fairness norms.
• 2 stages: VC and E negotiate financial
contract.
• Then both exert value-adding efforts.
Page 186
186
How to model fairness?
Fairness Norms.
• Fair VCs and Es in society.
• self-interested VCs and Es in society.
• Matching process: one E emerges with a
business plan. Approaches one VC at
random for finance.
• Players cannot observe each other’s type.
rr1
Page 187
187
Timeline
• Date 0: VC makes ultimatum offer of equity stake to E;
• Date 1: VC and E exert value-adding effort in running the business
• Date 2 Success Probability
• => income R.
• Failure probability
• =>income zero
1],1,0[
VCEEE eeP
P1
Page 188
188
• Expected Value of Project
• Represents VCs relative ability (to E).
ReePRV VCEEE )(
]1,0[
Page 189
189
Fairness Norms
• Fair VC makes fair (payoff equalising)
equity offer
• Self-interested VC makes self-interested
ultimatum offer
• E observes equity offer. Fair E compares
equity offer to social norm. Self-interested
E does not, then exerts effort.
F
FU
Page 190
190
Expected Payoffs
• PRrePR UFEUE )(
2
2])1)[(1(])1[( VCFUSUVC eRPrRPr
If VC is fair, by definition, FU
Page 191
191
Solve by backward induction:
• If VC is fair;
• Since
• for both E types.
• =>
• =>
FU 2
EFE ePR
FS PP
2)1( VCFVC ePR
Page 192
192
VC is fair; continued.
• Given FU
Optimal Effort Levels:
.2
)1(*,
2*
Re
Re EF
VCEF
E
Fair VC’s equity proposal (equity norm):
)1(3
1212
242
F
Page 193
193
VC is self-interested:
• From Equation (1), fair E’s optimal effort;
•
FSFU PP
.2
)]([*
Rre EUFU
E
Page 194
194
Self-interested VC’s optimal
Equity proposal
• Substitute players’ optimal efforts into V=
PR, and then into (1) and (2). Then, optimal
equity proposal maximises VC’s indirect
payoff =>
.)1(2
)1(1*
22
22
r
r FU
Page 195
195
Examples;
• VC has no value-adding ability (dumb
money) =>
• =>
•
• r =0 =>
• r => 1 ,
03
2F
.2
1U
.3
2 FU
Page 196
196
Example 2
• VC has equal ability to E;
=>
• r =0 =>
• r => 1 ,
• We show that
as r => 1
12
1F
.0U
.2
1 FU
],1,0[ FU
Page 199
199
Table of venture performance
Page 200
200
Graph of Venture Performance.
Page 201
201
Future Research.
• Dynamic Fairness Game:ex post
opportunism (Utset 2002).
• Complementary Efforts.
• Trust Games.
• Experiments.
• Control Rights.
Page 202
202
Private Equity
• JCF paper: slides to follow…
• PE and leverage: slides to follow….
Page 203
203
Lecture 10: Introduction to Behavioural
Corporate Finance.
•Standard Finance - agents are rational and self-
interested.
•Behavioural finance: agents irrational
(Psychological Biases).
•Irrational Investors – Overvaluing assets-
internet bubble? Market Sentiment?
•Irrational Managers- effects on investment
appraisal?
•Effects on capital structure?
•Herding.
Page 204
204
Development of Behavioral Finance I.
• Standard Research in Finance: Assumption: Agents are rational self-interested utility maximisers.
• 1955: Herbert Simon: Bounded Rationality: Humans are not computer-like infinite information processors. Heuristics.
• Economics experiments: Humans are not totally self-interested.
Page 205
205
Development of Behavioral Finance II.
• Anomalies: Efficient Capital Markets.
• Excessive volatility.
• Excessive trading.
• Over and under-reaction to news.
• 1980’s: Werner DeBondt: coined the term Behavioral Finance.
• Prospect Theory: Kahnemann and Tversky 1980s.
Page 206
206
Development III
• BF takes findings from psychology.
• Incorporates human biases into finance.
• Which psychological biases? Potentially
infinite.
• Bounded rationality/bounded
selfishness/bounded willpower.
• Bounded rationality/emotions/social factors.
Page 207
207
Potential biases.
• Overconfidence/optimism
• Regret.
• Prospect Theory/loss aversion.
• Representativeness.
• Anchoring.
• Gambler’s fallacy.
• Availability bias.
• Salience….. Etc, etc.
Page 208
208
Focus in Literature
• Overconfidence/optimism
• Prospect Theory/loss aversion.
• Regret.
Page 209
209
Prospect Theory.
W
U
Eg: Disposition Effect:
Sell winners too quickly.
Hold losers too long.
Risk-averse in
gains
Risk-seeking in losses
Page 210
210
Overconfidence.
• Too much trading in capital markets.
• OC leads to losses?
• But : Kyle => OC traders out survive and
outperform well-calibrated traders.
Page 211
211
Behavioral Corporate Finance.
• Much behavioral research in Financial
Markets.
• Not so much in Behavioral CF.
• Relatively new: Behavioral CF and
Investment Appraisal/Capital
Budgeting/Dividend decisions.
Page 212
212
Forms of Irrationality.
a) Bounded Rationality (eg Mattson and Weibull 2002, Stein
1996).
- Limited information: Information processing has a cost of
effort.
- Investors => internet bubble.
b) Behavioural effects of emotions:
-Prospect Theory (Kahneman and Tversky 1997).
- Regret Theory.
- Irrational Commitment to Bad Projects.
- Overconfidence.
C) Catering – investors like types of firms (eg high dividend).
Page 213
213
Bounded rationality (Mattson and Weibull 2002).
-Manager cannot guarantee good outcome with probability of 1.
-Fully rational => can solve a maximisation problem.
-Bounded rationality => implementation mistakes.
-Cost of reducing mistakes.
-Optimal for manager to make some mistakes!
-CEO, does not carefully prepare meetings, motivate and monitor
staff => sub-optimal actions by firm.
Page 214
214
Regret theory and prospect theory (Harbaugh 2002).
-Risky decision involving skill and chance.
-manager’s reputation.
Prospect theory: People tend to favour low success probability
projects than high success probability projects.
-Low chance of success: failure is common but little reputational
damage.
-High chance of success: failure is rare, but more embarrassing.
Regret theory: Failure to take as gamble that wins is as
embarrassing as taking a gamble that fails.
=> Prospect + regret theory => attraction for low probability
gambles.
Page 215
215
Irrational Commitment to bad project.
-Standard economic theory – sunk costs should be ignored.
-Therefore- failing project – abandon.
-But: mgrs tend to keep project going- in hope that it will improve.
-Especially if manager controlled initial investment decision.
-More likely to abandon if someone else took initial decision.
Page 216
216
Real Options and behavioral aspects of ability to revise (Joyce
2002).
-Real Options: Flexible project more valuable than an inflexible
one.
-However, managers with an opportunity to revise were less
satisfied than those with standard fixed NPV.
Page 217
217
Overconfidence and the Capital Structure (Heaton 2002).
-Optimistic manager overestimates good state probability.
-Combines Jensen’s free cashflow with Myers-Majluf Assymetric
information.
-Jensen- free cashflow costly – mgrs take –ve NPV projects.
-Myers-Majluf- Free cashflow good – enables mgs to take +ve
NPV projects.
-Heaton- Underinvestment-overinvestment trade-off without
agency costs or asymmetric info.
Page 218
218
Heaton (continued).
-Mgr optimism – believes that market undervalues equity =
Myers-Majluf problem of not taking +ve NPV projects => free
cash flow good.
-But : mgr optimism => mgr overvalues the firms investment
opportunities => mistakenly taking –ve NPV project => free cash
flow bad.
-Prediction: shareholders prefer:
-Cashflow retention when firm has both high optimism and good
investments.
- cash flow payouts when firm has high optimism and bad
investments.
Page 219
219
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).
Page 220
220
Effect of Managerial overconfidence, asymmetric Info, and
moral hazard on Capital Structure Decisions.
Rational Corporate Finance.
-Capital Structure: moral hazard + asymmetric info.
-Debt reduces Moral Hazard Problems
-Debt signals quality.
Behavioral Corporate Finance.
-managerial biases: effects on investment and financing decisions
-Framing, regret theory, loss aversion, bounded rationality.
-OVERCONFIDENCE/OPTIMISM.
Page 221
221
Overconfidence/optimism
• Optimism: upward bias in probability of
good state.
• Overconfidence: underestimation of asset
risk.
• My model =>
• Overconfidence: overestimation of ability.
Page 222
222
Overconfidence: good or bad?
• Hackbarth (2002): debt decision: OC good.
• Goel and Thakor (2000): OC good: offsets
mgr risk aversion.
• Gervais et al (2002), Heaton: investment
appraisal, OC bad => negative NPV
projects.
• Zacharakis: VC OC bad: wrong firms.
Page 223
223
Overconfidence and Debt
• My model: OC => higher mgr’s effort
(good).
• But OC bad, leads to excessive debt (see
Shefrin), higher financial distress.
• Trade-off.
Page 224
224
Behavioral model of overconfidence.
Both Managers issue debt:
.ˆ,ˆ qqpp
.)ˆ1(ˆ2
ˆ bpqp
IpRpM g
.)ˆ1(ˆ2
ˆ bqqp
IqRqMb
Page 225
225
Good mgr issues Debt, bad mgr issues equity.
.)ˆ1(
ˆˆ bpI
p
pRpM g
.ˆ
ˆ Iq
qRqMb
Both mgrs issue equity.
,
ˆ2ˆ I
qp
pRpM g
.ˆ2
ˆ Iqp
qRqMb
Page 226
226
Proposition 1.
a) If
b)
,)ˆ1()ˆ1()(
)(ˆbpbqI
qpq
qpq
}.{ DSS bg
,)ˆ1()(
)(ˆ)ˆ1( bpI
qpq
qpqbq
}.,{ ESDS bg
c) ,)(
)(ˆ)ˆ1()ˆ1( I
qpq
qpqbpbq
}.{ ESS bg
Overconfidence leads to more debt issuance.
Page 227
227
Overconfidence and Moral
Hazard
• Firm’s project: 2 possible outcomes.
• Good: income R. Bad: Income 0.
• Good state Prob:
• True:
• Overconfidence:
• True success prob:
].1,0()( eP
.0
.0
.eP
Page 228
228
Manager’s Perceived Payoffs
.)ˆ1()(ˆˆ 2 IPDebPDRPMD
.)1(ˆˆ 2 IPReRPME
Page 229
229
Optimal effort levels
2
))((*
bDReD
2
))((*
DReE
Page 230
230
Effect of Overconfidence and
security on mgr’s effort
• Mgr’s effort is increasing in OC.
• Debt forces higher effort due to FD.
Page 231
231
Manager’s perceived Indirect
Payoffs
bIDbDRbDR
MD
2
))((
4
)()(ˆ22
IDDRDR
ME
2
))((
4
)()(ˆ22
.2
)(
4
))(2()(ˆ22
bbDbDRb
MD
Page 232
232
True Firm Value
.2
))()(()( b
bRbDRbbRPV DD
.2
))((
RDRRPV EE
Page 233
233
Effect of OC on Security Choice
024
))(2()0(ˆ
222
bbDbIRb
MD
0ˆ
DM
.0)(ˆ CDM
],,0[ C
,C
Manager issues Equity.
Manager issues Debt.
Page 234
234
Effect of OC on firm Values
.2
))()(()( b
bRbDRV CD
bDRRbDbbR
VD
2
)()2)(( 22
.2
)()0(
2
RDRVE
Page 235
235
Results
• For given security: firm value increasing in OC.
• If
• Firm value increasing for all OC: OC good.
• Optimal OC:
• If
• Medium OC is bad. High OC is good.
• Or low good, high bad.
,0)( CDV
,0)( CDV .* max
Page 236
236
Results (continued).
• If
• 2 cases: Optimal OC:
•
• Or Optimal OC:
,0)( CDV
.* max
.* C
Page 237
237
Effect of Overconfidence on Firm Value
-600
-400
-200
0
200
400
600
800
1000
1200
0 0.1 0.2 0.3 0.4 0.5
Overconfidence
Valu
e
Effect of Overconfidence on Firm Value
-2000
-1500
-1000
-500
0
500
1000
1500
2000
2500
1 2 3 4 5 6 7 8 9 10
Overconfidence
Valu
e
Effect of Overconfidence on Firm Value
-2000
-1500
-1000
-500
0
500
1000
1500
2000
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9
OverconfidenceV
alu
e
Page 238
238
Conclusion.
• Overconfidence leads to higher effort level.
• Critical OC leads to debt: FD costs.
• Debt leads to higher effort level.
• Optimal OC depends on trade-off between
higher effort and expected FD costs.
Page 239
239
Future Research
• Optimal level of OC.
• Include Investment appraisal decision
• Other biases: eg Refusal to abandon.
• Regret.
• Emotions
• Hyperbolic discounting
• Is OC exogenous? Learning.
Page 241
241
Hyperbolic Discounting
Page 242
242
Emotional Finance
• Fairchild’s Concorde case study.