MSC Semester 2, 2003: Company Finance Richard Fairchild: http://staff.bath.ac.uk/mnsrf . Room: WH9.21 Email: [email protected] Topics in Investment Appraisal. Risk and Return/ Portfolio Analysis. 3. Cost of Capital, Capital Structure, Firm Value. - PowerPoint PPT Presentation
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-divisional mgr is an empire builder- submits bigger project with lower NPV – hides smaller project with higher NPV.
-IRR or PI performs better.
31
SECTION 2: Cost Of Capital.
The cost of capital = investors’ required return on their investment in a company.
It provides the appropriate discount rate in NPV.
Investors are risk averse.
Future share prices (and returns) are risky (volatile).
The higher the risk, the higher the required return.
p
t
r
t
100*1
1
t
ttt P
PPr
A
B
32
Risk and Return.
An investor’s actual return is the percentage change in price:
100*1
t
tt
P
PPR
Risk = Variability or Volatility of Returns, Var (R).
We assume that Returns follow a Normal Distribution.
E(R)
Var(R).
./)....)( 21 TRRRAverageRE T
33
What do we mean by Risk?
The risk reflects the distribution (spread) of expected future returns.
Investors are assumed to be risk-averse (don’t like risk).
The higher the spread (risk), the higher the required return => current price adjusts to reflect this.
Risk.
A
B
B is riskier than A.
A
B
Time
Returns
34
Risk Aversion.
Investors prefer more certain returns to less certain returns.
Wealth
U
150100 200
Risk Averse Investor prefers £150 for sure than a 50/50 gamble giving £100 or £200.
35
Portfolio Analysis.
Two Assets: Investor has proportion a of Asset X and (1-a) of Asset Y.
).()1()(.)( YXp REaREaRE
).,(.2)(.)1()(.)( 22 yxCovabYVaraXVaraRVar p
Combining the two assets in differing proportions.
E(R)
36
Portfolio of Many assets + Risk Free Asset.
E(R)
*
*
* * *
*fr
M.Efficiency Frontier.
All rational investors have the same market portfolio M of risky assets, and combine it with the risk free asset.
A portfolio like X is inefficient, because diversification can give higher expected return for the same risk, or the same expected return for lower risk.
X
37
The Effect of Diversification on Portfolio Variance.
P
Number of Assets.
An asset’s risk = Undiversifiable Risk + Diversifiable Risk
= Market Risk + Specific Risk.
Market portfolio consists of Undiversifiable or Market Risk only.
38
Summary of Risk and Return:
Investors are assumed to be risk averse.
They combine assets to diversify (reduce) risk.
The more assets, the lower the specific risk.
The market portfolio diversifies away all specific risk, and contains all assets in the right proportions.
Implications for Investors.
Current share prices (which affect expected returns) are such that the market only rewards investors for holding market risk, not specific risk.
*****Implications for Individual Firms. ***********
Cost of Capital (Investor’s required return) should only reflect Market Risk – (Beta – CAPM).
39
Cost of Equity.
Dividend Valuation Model.
.
.)1(
1
10
gK
DivV
gV
Divg
V
gDivK
ee
eee
This assumes that all net cashflows are paid out as dividends.
Interchangeability- if we know the dividends and the market value, we can calculate the cost of equity.
If we know the cost of equity and the dividends, we can calculate the market value.
40
Cost of Equity (continued)
CAPM
.])([)( fmfi rrErrE
quantity of risk.
)(rE
fr
1
)( mrE
Security Market Line.
41
Estimating Cost of Equity Using Regression Analysis.
We regress the firm’s past share price returns against the market.
.
.
i
imii
b
rbar
ir
mrSee the regression exercise on my home page.
42
Weighted Average Cost of Capital (WACC).
When we have estimated Cost of Debt, and Cost of Equity-
if we have market values of debt and equity, we can calculate WACC – discount rate for new investments.
...
de
ddee
VV
KVKVWACC
See Mobil Energy Exercise.
43
Link to Section 3: Link between Value of the firm and NPV.
Positive NPV project immediately increases current equity value (share price immediately goes up!)
oo EBV Pre-project announcement
New project: .IVNPV n INew capital (all equity)
I
Value of Debt oBIVE n 0
New Firm Value
Original equity holders
New equity
nVV
44
Example:
oo EBV =500+500=1000.
I IVNPV n 60 -20 = 40.
oB = 500.
IVE n 0 = 500+40 = 540
I = 20
nVV =1000+60=1060.
200
Value of Debt
Original Equity
New Equity
Total Firm Value
45
Positive NPV: Effect on share price.
Assume all equity.
Market No of Price per Market No of Price per£K Value Shares Share Value Shares Share
Current 1000 1000 1 1040 1000 1.04
New Project 20 19 1.04
Project Income 60 1060 1019 1.04
Required Investment 20
NPV 40
46
SECTION 3: Value of the Firm and Capital Structure.
Introduction:-
Value of the Firm = Value of Debt + Value of Equity = discounted value of future cashflows available to the providers of capital.
(where values refer to market values).
Capital Structure is the amount of debt and equity: It is the way a firm finances its investments.
Unlevered firm = all-equity.
Levered firm = Debt plus equity.
Miller-Modigliani said that it does not matter how you split the cake between debt and equity, the value of the firm is unchanged (Irrelevance Theorem).
47
Value of the Firm = discounted value of future cashflows available to the providers of capital.
-Assume Incomes are perpetuities.
Miller- Modigliani Theorem:
..)1(
.
)1(
d
dDEUL
EC
U
K
Bk
eK
NIVV
WACC
TNCFBTVV
VTNCF
V
Irrelevance Theorem: Without Tax, Firm Value is independent of the Capital Structure.
Note thatV
VTKVKWACC ddee ).1(.
48
K
D/E
K
D/E
V
D/E D/E
V
49
Which Cashflows do we use?
Annual Income statement:
Revenues 1000
Less Variable Costs 200
Less Fixed Costs 200
EBIT (=NCF) 600
Less Debt Interest (2000 @ 5%) 100 for debtholders
EBT 500
Less Tax (20%) 100
Net Income (NI) 400 for equityholders
50
Calculating Levered Firm Value in our Numerical Example (see Income Statement).
Let Cost of levered Equity:
Market Value of Debt = 2000. Cost of risk free Debt = 5%.
MM assumed that investment and financing decisions were separate. Firm first chooses its investment projects (NPV rule), then decides on its capital structure.
Pie Model of the Firm:
D
E
E
52
MM irrelevance theorem- firm can use any mix of debt and equity – this is unsatisfactory as a policy tool.
Searching for the Optimal Capital Structure.
-Tax benefits of debt.
-Asymmetric information- Signalling.
-Agency Costs (selfish managers).
-Debt Capacity and Risky Debt.
Optimal Capital Structure maximises firm value.
53
Combining Tax Relief and Debt Capacity (Traditional View).
D/E D/E
V
K
54
Section 4: Optimal Capital Structure, Agency Costs, and Signalling.
Agency costs - manager’s self interested actions. Signalling - related to managerial type.
Debt and Equity can affect Firm Value because:
- Debt increases managers’ share of equity.
-Debt has threat of bankruptcy if manager shirks.
- Debt can reduce free cashflow.
But- Debt - excessive risk taking.
55
AGENCY COST MODELS.
Jensen and Meckling (1976).
- self-interested manager - monetary rewards V private benefits.
- issues debt and equity.
Issuing equity => lower share of firm’s profits for manager => he takes more perks => firm value
Issuing debt => he owns more equity => he takes less perks => firm value
56
Jensen and Meckling (1976)
B
V
V*
V1
B1
A
If manager owns all of the equity, equilibrium point A.
Slope = -1
57
B
V
Jensen and Meckling (1976)
V*
V1
B1
AB
If manager owns all of the equity, equilibrium point A.
If manager owns half of the equity, he will got to point B if he can.
Slope = -1
Slope = -1/2
58
B
V
Jensen and Meckling (1976)
V*
V1
B1
AB
C
If manager owns all of the equity, equilibrium point A.
If manager owns half of the equity, he will got to point B if he can.
Final equilibrium, point C: value V2, and private benefits B1.
V2
B2
Slope = -1
Slope = -1/2
59
Jensen and Meckling - Numerical Example.PROJECT PROJECTA B
EXPECTED INCOME 500 1000
MANAGER'S SHARE:100% 500 1000
VALUE OF PRIVATE 800 500BENEFITS
TOTAL WEALTH 1300 1500
MANAGER'S SHARE:50% 250 500
VALUE OF PRIVATE 800 500BENEFITS
TOTAL WEALTH 1050 1000
Manager issues 100% Debt.
Chooses Project B.
Manager issues some Debt and Equity.
Chooses Project A.
Optimal Solution: Issue Debt?
60
Issuing debt increases the manager’s fractional ownership => Firm value rises.
-But:
Debt and risk-shifting.
Project 1 Project 2 Probability
State 1 100 0 0.5
State 2 100 160 0.5
100 80
Values: Debt 50 25
Equity 50 65
61
OPTIMAL CAPITAL STRUCTURE.
Trade-off: Increasing equity => excess perks.
Increasing debt => potential risk shifting.
Optimal Capital Structure => max firm value.
D/E
V
D/E*
V*
62
Other Agency Cost Reasons for Optimal Capital structure.
Akerlof showed that, under assymetric info, only bad things may be traded.
His model- two car dealers: one good, one bad.
Market does not know which is which: 50/50 probability.
Good car (peach) is worth £2000. Bad car (lemon) is worth £1000.
Buyers only prepared to pay average price £1500.
But: Good seller not prepared to sell. Only bad car remains.
Price falls to £1000.
Myers-Majuf (1984) – “securities may be lemons too.”
71
Asymmetric information and Signalling Models.
- managers have inside info, capital structure has signalling properties.
Ross (1977)
-manager’s compensation at the end of the period is
DVCVVrM
DVVVrM
11100
11100
if )1(
if )1(
D* = debt level where bad firm goes bankrupt.
Result: Good firm D > D*, Bad Firm D < D*.
Debt level D signals to investors whether the firm is good or bad.
72
Myers-Majluf (1984).
-managers know the true future cashflow.
They act in the interest of initial shareholders.P = 0.5 Do
Nothing:
Good Bad
IssueEquity
Good BadAssetsin Place
250 130 350 230
NPV ofnewproject
0 0 20 10
Value ofFirm
250 130 370 240
Expected Value 190 305
New investors 0 100
Old Investors 190 205
73
Consider old shareholders wealth:
Good News + Do nothing = 250.
Good News + Issue Equity =
Bad News and do nothing = 130.
.69.248)370(305
205
Bad News and Issue equity = .31.161)240(305
205
74
Donothing
Issueandinvest
GoodNews
250 * 248.69
BadNews
130 161.31*
Old Shareholders’ payoffs EquilibriumDonothing
Issueandinvest
GoodNews
250 * 248.69
BadNews
130 140 *
Issuing equity signals that the bad state will occur.
The market knows this - firm value falls.
Pecking Order Theory for Capital Structure => firms prefer to raise funds in this order:
Retained Earnings/ Debt/ Equity.
75
Evidence on Capital structure and firm value.
Debt Issued - Value Increases.
Equity Issued- Value falls.
However, difficult to analyse, as these capital structure changes may be accompanied by new investment.
More promising - Exchange offers or swaps.
Class discussion paper: Masulis (1980)- Highly significant Announcement effects:
+7.6% for leverage increasing exchange offers.
-5.4% for leverage decreasing exchange offers.
76
Section 5: Dividend Policy – Overview.
1. Miller Modigliani Irrelevance Theorem – Dividend Policy does not affect firm value, since Shareholders are only interested in Cashflow available.
2. Signalling – Dividend policy may affect firm value by signalling good or bad firm.
3. Gordon Growth Model – If growth comes from re-investing, then dividend policy may affect firm value.
4. Lintner Model – If managers care about signalling, then they may smooth the pattern of dividends over time.
77
Section 5: Dividend Policy.
Assume All equity firm.
Value of Firm = Value of Equity = discounted value of future cashflows available to equity holders = discounted value of dividends (if all available cashflow is paid out).
0
0
0
0
)1(
)1(
ttt
tt
INCFV
DivV
t
t
If everything not reinvested is paid out as dividends, then
78
Miller Modigliani’s Dividend Irrelevance.
NSDivINCF
DivINSNCF
tttt
tttt
Source of Funds = Application of Funds
MM used a source and application of funds argument to show thatDividend Policy is irrelevant:
11
0)1()1( tttt
tttt INCFNSDiv
V
79
1
0)1(tttt INCF
V
-Dividends do not appear in the equation.
-If the firm pays out too much dividend, it issues new equity to be able to reinvest. If it pays out too little dividend, it can use the balance to repurchase shares.
-Hence, dividend policy irrelevant.
-Key is the availability of finance in the capital market.
80
Example of Dividend Irrelevance using Source and Application of Funds.
Firm invests in project giving it NCF = 100 every year, and it needs to re-invest, I =50 every year.
Cashflow available to shareholders = NCF – I = 50.
Now, NCF – I = Div – NS = 50.
If firm pays dividend of 50, NS = 0 (ie it pays out exactly the cashflow available – no new shares bought or sold).
If firm pays dividend of 80, NS = -30 (ie it sells new shares of 30 to cover dividend).
If firm pays dividend of 20, NS = 30 (ie it uses cashflow not paid out as dividend to buy new shares).
In each case, Div – NS = 50.
81
Gordon Growth Model.
Where does growth come from?- retaining cashflow to re-invest.
.)1(11
0g
kNCFg
DivV
Constant fraction, K, of earnings retained for reinvestment.
Rest paid out as dividend.
Average rate of return on equity = r.
Growth rate in cashflows (and dividends) is g = Kr.
82
Example of Gordon Growth Model.£K 19x5 19x6 19x7 19x8 19x9 Average Profits After Tax (NCF) 2500 2760 2635 2900 3100Retained Profit (NCF.K) 1550 1775 1600 1800 1900
Comparison of MM Irrelevance, Gordon Growth, and Signalling.
A. In MM irrelevance, Dividends do not matter: NCF – I is fixed each period. Dividends and NS balance out. Capital freely available.
B. In Gordon Growth, NCF (1-K) = NCF – I = Divs.
No New shares. Increased Dividends => lower re-investment, lower growth => effect on firm value?
C. Signalling. High dividends => high firm value; low dividends => low firm value.
(See Boyesen Case Study.)
91
Section 6: Options and Risk Management.
A call option gives the holder the right (but not the obligation) to buy shares at some time in the future at an exercise price agreed now.
A put option gives the holder the right (but not the obligation) to sell shares at some time in the future at an exercise price agreed now.
European Option – Exercised only at maturity date.
American Option – Can be exercised at any time up to maturity.
For simplicity, we focus on European Options.
92
Factors Affecting Price of European Option (=c).
-Underlying Stock Price S.
-Exercise Price X.
-Variance of of the returns of the underlying asset ,
-Time to maturity, T.
.0,0,0,02
T
cc
X
c
S
c
2
The riskier the underlying returns, the greater the probability that the stock price will exceed the exercise price.
The longer to maturity, the greater the probability that the stock price will exceed the exercise price.
93
Combining options, graphic presentation.
Buying a Call Option.
S
WSelling a put option.
Selling a Call Option. Buying a Put Option.
94
S
WLong in Stock
Short in Stock
Buy a Bond
Sell a Bond
S + P = B + C.
S + P – C = B. => risk-free profile.
Other Combinations: Spread, Straddle, Straps and strips.
See Exercise.
Put-call parity =>.
95
S
W
Long in Stock
Options And Risk Management.
Sell a Call Option.Plus
W
S
+S
- C
S - C
W
S
W
S
Plus buy a put: S + P – C = B.
S + P – C = B.
96
Another Example: Straddle.
Buy a Call Plus buy a Put.W
S
C + P
A straddle loses money for small changes in the stock price, and gains for large changes.
But, in an efficient market, we pay a fair price for this (as always).
97
Equity as a Call Option.
Black and Scholes pointed out that equity is a call option on the value of the levered firm.
If Value of firm exceeds face value of debt (exercise price of call option), equityholders pay the exercise price, and gain the increase in value.
If value of firm is less than face value of debt, option is not exercised.
Risky debt = risk-free debt – put option (B – P).
98
Important Implications for Firm.
Equity is a call option: Value of Equity increases with risk.
Value of Put option increases with risk: Therefore value of debt decreases with risk.
After all, Equity holders have limited liability, and
S = Max [ 0, V – D ]. B – P = Min [ V, D ].
With (B – P) + S = V.
Therefore, if S increases, ( B – P) decreases.
Equity holders will want to choose riskier projects.
99
Pricing Call Options – Binomial Approach.
S=20
q
1- q dS=13.40
uS=24.00
S = £20. q=0.5. u=1.2. d=.67. X = £21.
1 + rf = 1.1.
Risk free hedge Portfolio: Buy One Share of Stock and write m call options.
uS - mCu = dS – mCd => 24 – 3m = 13.40.
M = 3.53.
By holding one share of stock, and selling 3.53 call options, your payoffs are the same in both states of nature (13.40): Risk free.
cq
1- q
Cu = 3
Cd=0
100
Since hedge portfolio is riskless:
.))(1( uf mcuSmcSr
1.1 ( 20 – 3.53C) = 13.40.
Therefore, C = 2.21.
This is the current price per call option. The total present value of investment = £12 .19, and the rate of return on investment is
13.40 / 12.19 = 1.1.
101
Application of Options- Convertible Debt.
Convertible Debt gives the holder the right (but not the obligation) to convert bonds into equity at a future date.
Convertible debt is a combination of straight debt plus a call option.
We saw that straight debt = risky debt – a put option.
CD = D + C = B – P + C .
Implication: Value of Convertible debt increases with risk of firm’s cashflows, and time to maturity.
102
Risk Management.
Types of risk.
-Interest rate risk.
-exchange rate risk.
-operating risks
Integrated risk management approach.
Two Main Questions:-
How do Managers engage in Risk Management?
Should Managers even bother?
103
How to risk manage (Smith and Smithson).
Use of derivatives.
Interest rate, exchange rate instruments.
Meulbroek-
a) Modify firm’s operations
b) Adjust capital structure
c) Employ targeted financial Instruments.
Need for an integrated risk management policy (explain?)
104
Why bother risk-managing? (Meulbroek (2002), Shapiro and Titman
Argument for risk-mgt irrelevance
-A firm’s total risk consists of market risk (beta) and specific risk.
-Well-diversified investors have already got rid of each firm’s specific risk.
-Investors rewarded for holding market risk only (see CAPM).
-Risk Management is at best irrelevant (cannot add value)- (like MM’s capital structure irrelevance).
-At worst, a wasteful negative NPV activity (ie wasted resources, time and effort).
105
Argument for risk-management relevance (Meulbroek (2002), Shapiro and Titman
Risk-management by firm is value-adding;-
a) Inside info may make risk mgt easier for firms than investors.
b) Financial distress.
c) Non-diversified investors (such as managers themselves!!)
d) Risk-mgt and management incentives (eg risk-shifting).
e) Risk-mgt and debt capacity.
106
NPV analysis of risk mgt irrelevance/ relevance.
.......)1()1(1 3
32
210
K
X
K
X
K
XV
K = WACC, includes cost of equity (CAPM).
Investors have eliminated all specific risk – remaining market risk is in K.
Risk mgt will not affect K => cannot add value.
Shapiro and Titman – total risk => financial distress (FD) => reduces expected cashflows X.
Risk mgt reduces total risk=> affects FD and X => value adding.
107
Section 7: Convertible Debt.
-Valuation of Convertibles.
-Impact on Firm Value.
-Why firms issue convertibles.
-When are they converted (call policy)?
Convertible bond -holder has the right to exchange the bond for common stock (equivalent to a call option).
Conversion Ratio = number of shares received for each bond.
Value of Convertible Bond = Max{ Straight bond value, Conversion Value} +option value.
108
Value of Convertible Bond. (Occidental Electric Case Study)
Straight Bond Value Conversion Value
Total Value of Convertible Bond
V
Firm Value Firm Value
Firm Value
Face Value
109
Conflict between Convertible Bond holders and managers.
Convertible Bond = straight debt + call option.
Value of a call option increases with:
Time.
Risk of firm’s cashflows.
Implications: Holders of convertible debt maximise value by not converting until forced to do so => Managers will want to force conversion as soon as possible.
Incentive for holders to choose risky projects => managers want to choose safe projects.
110
Reasons for Issuing Convertible Debt.
Much real world confusion.
Convertible debt - lower interest rates than straight debt.
=> cheap form of financing?
No! Holders are prepared to accept a lower interest rate because of their conversion privilege.
CD =
.)1()1(
.)1()1(
1
1
ND
N
tt
D
D
NC
N
tt
C
C
K
M
K
I
K
PR
K
I
D =
.,, DCDKKMPRII CDCD
111
Alternative Analysis of Irrelevance of Convertible Debt.
Firm DoesBadly.
Firm DoesWell.
Convertible Debt.No Conversion. Conversion.
Compared with:Straight Bonds.
CD cheaperfinancing, lowercoupon rate.
CD expensive,Bonds areconverted,Existing EquityDilution.
Equity. CD expensive. CDs cheaper.
Firm Indifferent between issuing CD, debt or equity.
-MM.
112
Why do firms issue convertible debt?
If convertible debt is not a cheap form of financing, why is it issued?
A. Equity through the Back Door (Stein, Mayers).
-solves asymmetric information problems (see Myers-Majluf).
-solves free cashflow problems.
B. Convertible debt can solve risk-shifting problems.
- If firm issues straight debt and equity, equity holders have an incentive to go for risky (value reducing) NPV projects.
Since CD contains an option feature, CD value increases with risk.
-prevents equity holders’ risk shifting.
113
Convertible Debt and Call Policy.
Callable Convertible debt =>firms can force conversion.
When the bond is called, the holder has 30 days to either:
a) Convert the bond into common stock at the conversion ratio, or
b) Surrender the bond for the call price.
When should the bond be called?
Option Theory: Shareholder wealth is maximised/ CD holders wealth is minimised if
Firm calls the bond as soon as value = call price.
114
Call Puzzle.
Manager should call the bond as soon as he can force conversion.
Ingersoll (1977) examined the call policies of 124 firms 1968-1975.
- He found that companies delayed calling far too long.
- median company waited until conversion value was 44% above call price - suboptimal.
Call Puzzle addressed by Harris and Raviv.
- signalling reasons for delaying calling.
- early calling might signal bad news to the market.
115
Section 8: Takeovers.
Takeovers
Acquisition
Proxy Contest
Merger
Stock Acquisition
1. Merger- must be approved by stockholders’ votes.
2. Stock acquisition- No shareholder meeting, no vote required.
-bidder can deal directly with target’s shareholders- bypassing target’s management.
- often hostile.
-shareholders may holdout- freerider problems.
3. Proxy Contests- group of shareholders try to vote in new directors to the board.
116
Synergy =
Synergy =
Example: Market Value after Merger.
Firm A (bidder): cashflows = £10m, r = 10%. = £100m.
Firm B (target): cashflows = £9m, r = 15%. = £60m.
If A acquires B: Cashflows are expected to increase by £6m P.A. Discount rate 20%.
Synergy = £30m.
= $190m.
).( VVV BAAB
.1 )(
r
CFtt
V A
V AB
V B
117
The NPV of a merger.
Firm A may have to pay a premium to acquire firm B.
If firm A has to pay cost C to acquire firm B,
).()( VCVVVNPV BBAAB
In our example, if C = 70,
NPV of the merger to firm A = 30 - 10 = 20.
Therefore, the gain from synergy can be divided between the bidder and the target - affected by the premium.
(See Clifton Corporation Case Study).
=> models by Garvey and Hanka, and Grossman and Hart.
NPV = Synergy - Premium.
118
Garvey and Hanka: Management of Corporate Capital Structure.
- Hostile takeovers, and US antitakeover laws of 1980’s.
- dynamic defensive capital structure model.
-Results-
A. When takeover is easy => manager defends, increasing leverage => increases firm value => reduces takeover threat.
B. When takeover is more difficult => manager reduces leverage to reduce financial distress.
Optimal debt level maximises firm value.
119
- Manager’s optimal debt level minimises the threat of financial distress and minimises takeover threat.
If no takeover threat, manager chooses D < R + - no financial distress.
As takeover threat increases, manager increases D towards D* => V increases => reduces takeover threat.
.min
120
Take-over Bids and the Freerider Problem (Grossman and Hart (----).
- Market value per share under current management = Q.
- Market value per share under optimal management = V.
Price per share offered by raider = P, with Q < P V.
Freerider problem - If shareholder accepts offer, he gets P.
If shareholder refuses, but bid succeeds, he gets V.
Therefore, all shareholders refuse - bid fails.
Eg: Q = 10, V = 100. P = 20.
Each shareholder will not tender for anything less than 100 -raid fails.
121
Dilution - allows raider to take some of the firm’s value if successful.
Eg: dilution = 10 (lump sum payment to raider).
Successful raid: net value to shareholders = 100 - 10 = 90.
Tender offer = 91. Bid succeeds.
Implication of Garvey and Hanka, and Grossman and Hart.
-Corporate Governance (disciplining) role of Takeovers.
- Takeovers increase firm value (socially desirable).
- Takeovers may be difficult to achieve due to defensive strategy, or freerider price ‘run-ups’.
- Successful takeovers - most of the gains go to the target shareholders.
122
Effects of takeovers on stock prices of bidder and target.
TakeoverTechnique
Target Bidders
TenderOffer
30% 4%
Merger 20% 0
ProxyContest
8% n.a
TakeoverTechnique
Target Bidders
TenderOffer
-3% -1%
Merger -3% -5%
ProxyContest
8% n.a
Successful Bids Unsuccessful Bids
Jensen and Ruback JOFE 1983
123
Valuing a Merger.
• Firm X is bidding for firm Y.
• Firm X current f/c cashflows: £100m P.A.
• Firm Y current F/c cashflows: £50m P.A.
• Risk-free rate 5%.
• Expected return on market 10%.
• Firm X: beta = 1.0.
• Firm Y: beta = 0.8.
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Post-merger.
• Combined company X + Y: beta = 1.5
• Combined cashflows X + Y: £300m.
• What is synergy value?
• What is gain in shareholder wealth (for X and Y)?
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Step 1: calculate pre-merger values.
• CAPM: Ke (firm X) = 10%.
• CAPM: Ke (Firm Y) = 9%.
• DVM:
• g=0.
• V0(Firm X) = £1000m.
• V0 (Firm Y) = £555m.
g
gDV
)1(00
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Step 2: Calculate post-merger value.
• CAPM: Ke (A + B) = 12.5%
• V0 (A + B) = £2400m.
• Synergy Value = 2400 – 1000 – 555 = 845m (Total NPV of merger)
• Which shareholders (X or Y) get this?
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NPV of the Merger.
).()( BYXXYX VCVVVNPV
).555()5551000(2400 CNPVX
X pays full value: C = 1400 => NPV X = 2400 –1555 – 845 = 0.
NPV Y = 1400 - 555 = 845.
X pays pre-merger value: C = 555 => NPV X = 845.
NPV Y = 555 – 555 = 0.
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Which is most likely?
• Free-rider problems.
• Defensive use of capital structure.
• Other defenses (poison pills; anti-takeover amendments etc).
• Multiple bidders.
• EMH.
• Real Option approach.
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Real Option Approach (AK).
• Single Bidder X.• Single Target Y.• Bidder decides whether to make bid.• Target decides whether to accept.• Standard model: X just bids pre-bid value