Advanced Corporate Finance

Notes
Week 1
Overview:

 Key issues are:

 Investment Policies: Which projects are good?
 Financing Policies: How do we finance the chosen projects?
 Payout Policies: How to return investments to investors?

Financial Analysis:
 ROE = NI / SE, normally 10-20%; found via past & relevant competition
 Driven by ROA (operations), capital structure & risks
 ROA = NI/Sales x Sales/TA (Profit / Asset Turnover)
 Respectively driven by profit per sale & sales per invested assets
 Reformulation separates operating & financing components to show
actual sources of profitability
 DO NOT MEMORIZE IF SPECIFIC ACCOUNT IS OP/FIN!
 Financial assets include cash & equivalents, ST investments & LT debt;
operating is everything else
 Financial liabilities include ST/LT loans & notes, current LT debt
portions, lease obligations & preferred shares; operating is everything
else & common shares
 Op Assets + Fin Assets = Op Liabilities + Fin Obligations + Equity
 NFE = Net Fin Exp
OI = Op Income
RNOA = Reformulated
NOA; = Op Profit
Margin/Sales
FLEV = Fin Leverage
NBC = Net Borrow Costs
NFE/NFO
ATO = Sales /NOA

 Spread increases in line with RNOA, but inversely to NBC, if NBC > RNOA
will decrease ROE
 FLEV only increases ROE when RNOA > NBC
 Current Ratio should be 1-3 to prevent risk & maximize efficiency of asset
use

Week 2
Valuation Myths:

 Are objective searches for “true value”

 All biased, direction & magnitude proportional to both payment & by
whom
 Good valuation precisely estimates value
  No such thing / “imagination”
 More quantitation = better valuation
 More model inputs reduce user understanding / law of diminishing
returns
 Universal reliable model exists
 Different professions have different valuation cultures, other factors
less important

Approaches:

 Direct SE value estimate via Dividend Discount / Residual Earnings models

 Indirect via company value estimate – debt value via Discounted Cash
Flow / Residual Operating Income models
 Relative valuations based on multiples

Forecasting-Based Models - Direct Approaches:

∞
Expected Equity Payoffs t
 Equity Value= ∑ (1 + Equity Cost )t
& sum of:
t=1

 PV of expected payoffs for next T years of growth stage, each

T
Payoff t
discounted separately: PVGSP = ∑ t
t =1 (1 +r )

Payoff T +1
 PV of expected payoffs after T growth time: Terminal Value T =
r-g
Terminal Value T
 Discount terminal value to today: Terminal PV =
( 1 + r )T
T
Payoff t Terminal valueT
 Valuet = 0 = ∑ t
+
t =1 (1+ r ) (1+ r )T
∞
Expected Firm Payoffs t
 Firm Value = ∑
t =1 (1 +WACC )t
 Growth Stage: T years, forecasted annually for each year
 Steady Stage: After year T to ∞, constant payoff growth rate
 Dividend Discount Model: what shareholders get from the firm
 EV = PV of actual shareholder receipts via discounting all future
dividends to today
 Separates forecasted dividends up to T from terminal value
capturing perpetual growth thereafter
T
dt
 General: V 0 = ∑ ¿ ¿ ¿ ¿ ; V = equity value t=0, r = equity cost / req return
E

t =1
T
dt 1 d T +1
Forecast & terminal periods (pre/post T): V 0 = ∑
E
 t
+ t
( )
t =1 (1 + r e ) (1 + re) r e - g
 Easy concept: divs = shareholder receipts, stable & predictable in
short-term
 Irrelevance from distribution, typically later than value creation
 Best when payout permanently tied to value generation (divs/$)
 Residual Equity Model: expected return to book value, makes
residual/abnormal to earnings/income
 ReEt = Incomet - ¿ ¿)
Incomet
 ROE t =
Bt -1
 ReEt = B *(ROE - r e )
 EV = B + ReEpremium
∞
REt
 General Formula: Value0 = B0 + ∑ t
t =1 (1+ r e )
∞
REt 1 RE
 Pre + Post T: Value 0 = B0 + ∑ t
+ T
( T+1 )
t =1 (1+ r e ) (1 + re ) r e - g
 Focuses on profitability & investment growth, describing firm value
with accounting variables subject to analysis & forecasting, uses
accrual accounting properties of value recognition before CF & treats
investment as an asset
 Uses value already recognized on BS (EBV), reducing speculation
reliance
 However, it’s notably more complex & subject to accounting distortions

Forecasting-Based Models - Indirect Approaches:

 Firm Value = Debt Value + Equity Value

  FV = Operations Value , DV = NFO , t h us EV = OV - NFO
 Discounted Cash Flow Method:
 Free Cas h Flow Firm ( FCFF ) = Operating CF - Capital Expenditure
 FCFF = NOI - ∆ NOA
 FCFF is $ left in firm after capital investments, likely paid as
interest/divs
∞
FCFF t
 General: V 0 = ∑
E
t
- NFO 0
t =1 ( 1+ WACC )
T
FCFF t 1 FCFFT +1
 Pre + Post T: V 0 = ∑
E
t
+ ( )
t =1 (1 + WACC ) ( 1 + WACC )T WACC - g

 Formula Note: WACC = ( EV

FV
* r ) +(
e
FV )
DV
r *(1 - T )
d c

 Easy concept, as CF real & easy to grasp with straightforward PV

application
 However, less relevant from CF limitation, where FCFF can increase
from investment cutbacks, reframing it as value loss & not aligned with
forecasts
 Best when investment pattern makes positive constant / constant
growth FCF
 Residual Operating Income Model: Like ReEM, with focus on abnormal
operating profitability
 Measures incremental OI made after covering capital cost
 ReOI t = OI t - WACC * NOA t -1 or ReOI t =( RN OA t - WACC )* NOA t -1
 FV = NOA + ReOIPremium
∞
ReOI t
 General: V 0 = NOA 0 * ∑
F
t
t =1 (1+ WACC )
∞
ReOI t 1 ReOI T +1
 Pre + Post T: V 0 = ∑
F
t
+ ( )
t =1 ( 1+ WACC ) ( 1+ WACC )T WACC - g
 Best Model: Empirically evaluated over 5 years, 4% steady stage growth
in divs, FCF & ReE; ReEM showed lowest errors due to B (no estimate) &
ReE premium
 Model Challenges: too many inputs needing forecasting, with sensitive &
manipulable outcomes

Multiple-Based / Relative Valuations:

 Asset value compared to market value of comparables (e.g. PE ratio)

 Select comparable company set; found via statements, industry codes
&/ similar markets, customers, locations, etc.
 Compute mean/median multiple of comparables
  Multiply company earnings by computed multiple
 Easy with no estimates, but too simple?
 Popular with private equity & retail investors, especially in M&A, & for
forecasting model inputs

 Popular FV Multiples: FV-Sales, FV-CF, & Value-EBITDA Ratios

 Popular EV Multiples: PE & Market-Book Ratios

Week 3
Relative Valuation:

 Multiple Determinants: growth, profitability & risk, leverage & accounting

methods less so; mispriced if fundamental drivers can’t explain
differences
E D 1 D 0 (1+ g)
 CGDDM: V 0 = = ; / CGEarnings:
r-g r- g
E
P 0 V 0 D 0 1+ g 1+g
= = * = Payout *
E0 E0 E0 r-g r-g
 Investors are thus willing to pay more (P) for given E if they believe
firm:
D0
 Has greater potential g, less risk / decreasing r, will pay more ( ¿
E0
 Firms recognize investments at historical prices as BV, not the actual
value an investment generates for shareholders (depending on how much
managers can use it, more BV = more Payout, like with ReEMs last week)
E R1 ( ROE 1 - R ) B 0
 CGREM: V 0 = B 0 + = B 0+ ;
R-g R-g
E
P0 V0 ROE 1 - R ROE 1- g
B 0= = = 1+ =
B0 B0 R-g R-g
 Investors: more P for given B if firm: more profitable (ROE), less risky
(re), increased BE (g)
 Comparable Firms:
 Driven by growth, profitability & risk
 Assume similar: g, profitability (margins, turnovers), equity/capital
cost, P
 Truly comparable firms for many reasons (systemic bias, size, etc.)
 Multivariate Regressions:
 Sample all firms using price multiple (P/E) as dependent & risk, g, P,
etc. as independents, e.g. P / E = α + β 1 risk + β 2 growt h + β 3 payout + ε

 Using Singapore: P / E = 16.16 - 7.94 I +154.4 GDPG - 0.112CR

 Predicted PE =16.16 - ( 7.94 *6.5 % ) + (154.4 *5.2 % ) - ( 0.112*5 ) = 23.1
 Based on actual PE of 24, Singaporean firms overvalued
Estimating re & WACC:
 Need to estimate re / WACC via CAPM: ri = rf + βi *(rm - rf )
 Best rf estimate = 10/30y US T-Bill rate; check sovereign ratings &
compare
 Best rm-rf estimate = historical data; depends on sample length, T-Bill/T-
Bond rates, & averaging method

 Best β estimate = regression ri = α + βi* rm+ ε ; check R2 & β

 Factors: firm type, OpLev, FinLev; (

βL = βU 1+ ( 1 - Tc ) )
D
E
; βU =
D
βL
1+(1- Tc)
E
 Multi-business firm βL = levered/equity β, βU = unlevered/asset β:
k
βU = ∑ ( βUj *Wj ), Tc = corp tax rate, D/E = debt-equity ratio
j =1

Business risk = βL/ βU & Leverage risk = 1 – (βU/ βL)


E D
 WACC = * rE + * r * ( 1 - Tc ) ;
E+ D E+ D D
 rD = NBC , E = S #* SP , D= NFO , Tc = tax rate
(S #* SP) NFO
 WACC = *r E + * NBC * ( 1- Tc )
(S #* SP) + NFO (S #* SP)+ NFO

Private Firm Valuation:

 Forecast payoffs & discount appropriately
 Key Problems:
 No market value to calculate discount rate
 Hard to forecast future payoffs (FS less accurate & detailed, shorter
span) & wonky individual & company effects (e.g. failure to split salary
& divs)
 Example: High-end restaurant owner selling, need to value it:
 Buyer got large inheritance, 100% going into purchase
 Having 3y of FS, restaurant has no debt & 120K lease annually for 12y
 Steps:
 Estimate Discount Rate: regress historical stock returns against rm
to get β
 Private = no rm data, so can’t use it
 Find publicly listed list of similar restaurants (national > global)
 Regress historical returns against βm (1.24)
 To infer total β, find market & idiosyncratic components (R 2, 0.25)
βm 1.24
 Privateβ = = = 2.48; use correlation if given
√( R 2 ) √ 0.25
 Find re: rf = 1.54 % , UK rm - rf = 5.65 % , β = 2.48
 R = rf + βi * ( rm - rf ) = 1.54 %+ ( 2.48* 5.65 % ) = 15.6 %
 No debt means re = WACC
 Readjust FS:

 Account for Special Circumstances:

  After chef leaves, customers may follow; AOI(AT) 20% less:
150*0.8 = 120
 Forecast Horizons & Terminal Period Assumptions:
 Assume restaurant already in steady phase, terminal g = 2%
 Finalize Valuation:
 NOA = 500, its & OI(AT) g = 2%
 FCF 2025 = OI ( AT )2025 - ∆ NOA = 120 * ( 1.02 - 2 % ) * 500 =112400
FCF 2025 OI ( AT )2025 - ∆ NOA 112.4
 Value = = = = 826000
r-g r- g 15.6 %- 2 %

Week 4
Options, Options, Options!

 Traditional DCFM underestimate investment value, where firm can delay

investment, expand it (new markets &/ products), or abandon it
 Real Options: Options/rights to adjust ops via
delay/expansion/abandonment & allow addition of a premium to
traditional estimates (NPV & DCFM)
 E.G. E 2 = ( ( 0.33* 10 ) + ( 0.67 *- 10 ) ) ; if + =( ( 0.67 * 90 ) + ( 0.33 *- 110 ))

 Learning & adaptive behavior affect what can make them good/bad
 When investing, observe reality & adapt to increase potential upside
 Option Basics:
 Right to buy/sell asset at fixed price at/before expiry
 Not all investments have them & not all options have value
 If embedded, must be clearly defined underlying asset of
unpredictably changing value, with payoffs contingent on specific
event within a finite period
  Option has value if there’s a competition restriction in the event
of contingency, & one has exclusive advantage
 Determinants:
 Strike price: increases lessen call value & raise put value
 Life: value increases as expiry approaches
 Riskless rate related to life: increases will increase call value, and
lessen put value
 Replicating Portfolio:
 Goal is to combine riskless borrowing/lending & asset to = option value
 Call involves borrowing & buying Δ assets
 Put involves selling Δ assets & investment
 Option delta Δ is the # of assets to buy/sell
 Call Value =Current Asset Value * Δ - Replication Borrowing
 Binomial Model:
  Black-Scholes Model:
 OG made for European dividend-protected options, call value
function of:
 S = Current Asset Value (CAV)
 K = Option Strike Price (OSP)
 t = Option Life to Expiry (OLE)
 r = Life-Related Riskless Rate (LRR)
 σ 2= Asset Variance (AV)
 CV = S * N ( d 1 ) - K * e- rt N (d 2);
 N(d1) & N(d2) = cumulative normal distribution functions
 Replicating Portfolio embedded in BSM:
 Buy N(d1) stocks, N(d1) becomes Δ, borrow K e -rt N (d 2)
 CV = Share Price * Δ Borrowed
 Doesn’t account for dividend payments or early exercise
 BSM with Dividends: Yield assumed constant over option life
 CV = S e - yt N ( d 1 ) - K e -rt N ( d 2 )


d 1=
ln( )S
K
+ ( r - y - 0.5 σ 2) t
; d 2= d 1 - σ √ t
σ √t
Real Options Valuation:

 Delay (DO):
 Traditional analysis determines if project good/bad if taken today
 Bad project today (-NPV) may change as ECF discounts change
 When firm has exclusivity to project/product for period, can delay
taking it until later date
 Thus, not passing today doesn’t mean rights aren’t valuable
 Valuation Inputs:
 Asset Value: PV of ECF from immediate initiation
  Asset Value Variance: in CF of similar assets/firms & in PV variance
from capital budgeting simulation
 DOSP: DO exercised when firm invests; cost of investing = OSP
 Option Expiration: Patent/license life, relinquishment period,
inventory exhaustion time
 Delay Cost (Dividend Yield): Each year of delay = 1 year of CF (1/n)
 Patent Valuation:
 Patent gives firm right for commercial product development; will do
so if CFPV > development costs (DC), can shelve for free if not

 Patent Payoff (PP): PP=

o;V ≤ I{
V - I ;V >I
; I = DCPV & V = ECFPV

 Example: Biotech firm gets drug patent, estimate V as option

S CFPV of immediate drug introduction 5,000,000,000

K DCPV for drug’s commercial use 4,000,000,000
t Patent life 20 years
r 20y T-Bond rate 1.43%
σ2 Mean historical MV variance for listed 0.4
biotech
y Delay costs 1/n = 1/20 =
0.05
 d1, N(d1), d2 & N(d2): 1.2407,0.8926, -1.5877,0.0562 (GIVEN IN
EXAM)
 CV = ( 5 e -0.05 * 20 * 0.8926 ) - 4 e- 0.0143* 20 * 0.0562 = 1.47B
 Firms may delay patent (development) if they may gain more from
waiting; patent values increase alongside business risk
  Natural Resource Valuation:
 NR is asset, value based of price & quantity of it
 Often has DC, difference of extracted asset & DC = profit
 NRP = {
V - X ;V > X
0:V ≤ X
; X = DC, V = estimated value

 Example: Oil company has following profile:

Estimated reserves 50M S Estimated reserve (12*50)/

barrels value (lag 1.052 =
discounted) 544.22
Reserve DC 600M K DCPV of reserve 600
Development lag 2y t Time to option 20y
expiry
Exploitation right 20y r Riskless rate 0.08
Riskless rate 0.08 σ Oil price variance 0.03
2

Oil price variance 0.03 y Delay costs 0.05

MV/barrel (price = 12
MC)
Net production 5% dev
revenue/y value
FV per traditional -
DCFM 55.68M
 d1, N(d1), d2, N(d2) = 1.0359,0.8499,0.2613,0.6031 (GIVEN IN
EXAM)
 CV = ( 544.22 e -0.05 * 20 * 0.8499 ) - 600 e - 0.08* 20 * 0.6031 = 97.10M
  FV with DO = 97.10M – 55.68M = 41.42M
 NRFV = ECFDR + undeveloped reserve option value
 Conventional DCFM underestimates valuation of NRCs due to
missing option premium in undeveloped resources

 Expand:
 Taking project today may allow firm consideration of future projects
 Even though one may have -NPV, it may be worth it if EO compensates
 Valuation Example:
 OCT Park wants to open theme/water park, ENPV = -20M
 Assume if good, expand to Europe (150M in 10y, ECFPV = 100M)
 Value variance is 0.15 & 10y T-Bond rate is 0.065

 Expand option implicitly used to rationalize -NPV investments, but give

significant opportunities to tap new markets/products
 Involves strategic consideration, multistage investment & financial
flexibility, often used in value growth firms
 Abandon:
 Firm can scrap projects at certain stages if CF is insufficient
 If it saves firm from further losses, it can make projects more valuable
 PA = { 0 :V > L
L-V ;V ≤ L
; L = liquidation/abandonment value for project at same

point
 V = remaining value if project continues to end
 Valuation:
 Disney is considering JV with OCT for new project (500M for 50%,
ECFPV = 480M & AO for Disney to sell to OCT = 400M
 CF simulation yields CFPV variance of 0.16 & life = 30y

 AO may make unacceptable projects acceptable; all else equal may

attach more value to firms with:
  More cost flexibility (shifting FC into VC)
 Fewer LT customers & employee contracts/obligations (these add
scrap cost)
 While costing some value, AO must be weighted against increased
AO value

Week 5
Corporate Governance & Agency Problem:

 Difficulties financiers have ensuring funds not expropriated / wasted

 Incomplete contracts common issue around right of control & moral
hazards
 Effort hard to observe
 Divergent shareholder & management interests
 Max W / job security, publicity, money, career advancement, etc.
 Examples:
 Managerial Risk Aversion:
 Averse CEO foregoing risky but high NPV projects; need mechanisms
to motivate harder work & aversion negation
 Managerial Unethical Behavior:
 Recklessness & fraud; need punishment mechanisms
 Also deals with other stakeholders like employees, customers, suppliers,
etc.
 Wells Fargo Account Faking:
 Employees opened fake chequing accounts & credit cards, driven by
sales targets & compensation incentives, affecting millions of
customers
 Incentive system treated sales > ethics, internal controls failed due
to performance pressure-based risk culture
 Primark Child Labor Abuse:
  Alleged use from suppliers raised public concerns around supply
 Weak external boundaries, lack of supplier & subcontractor
monitoring & external stakeholder reputation risk

CG Objectives:

 Maximization of shareholder interests

 Equitable treatment of ALL shareholders
 Maximizing stakeholder interests & protecting them

CEO Compensation Approaches:

 Pay level, performance-pay sensitivity & pay structure

 Focusing on pay levels doesn’t align manager & owner interests &
don’t affect incentives, may just make people lazier and not better
 Pay sensitivity links it to performance via stock pay to boost short-term
effort but may reduce investment to inflate it or manipulate it with
accounting misconduct
 Structure around short & long-term efforts to encourage long-term
value creation
 Large CEO-worker pay gaps lead to higher productivity & innovation
but increase policy riskiness

Key CG Mechanisms:

 Board: Group Elected to represent shareholders, ensuring the CEO acts in-
line with their interests via monitoring & advising
 Typically includes chairman, external/independent & internal directors
 Independents allow objectivity & are hallmark
 Organized in Nominating (hiring/firing), Compensation, Audit & Risk
Committees; best when 50%+ external (100% for N & C Committees)
 Diversity may matter to outcomes (creativity innovation & decision-
making), but may distract & cause conflict

Large Shareholders:

 Institutional investors often have WDPs, actively involved via voice & exit
threats
 When distracted, CEOs are more likely to pointlessly merge, destroy
firm value, & less likely to be fired, but more likely to cut dividends &
grant themselves options

Other Mechanisms:

 Takeover Threats:
  If CEO is not effective/efficient with firm resources, other forms might
try to forcefully buy via hostile takeover (also governance mechanism,
somehow)
 Hostile takeovers significantly distress the CEO & other stakeholders;
when CEOs insulated: wages rise, productivity & profitability decline,
as well as both creation & destruction of new & old plants
 Product Market Competition:
 E.g. 2 industries, A has 1 monopoly, B has 10 firms selling essentially
same product
 CEOs in B are more able to tell which firm sells high-quality products
 Investors in B will be able to tell what constitutes good profitability
 Thus, governance problems are more severe for firms in A

Week 6
Capital Structure: Relative proportions of debt, equity etc. firm has
outstanding

 All corporate financial decisions guided by objective of firm value

maximization
 Assuming frictionless environment (no tax, transaction costs, borrowing &
∞
EBIT t EBIT
lending at same rate, can measure FV V 0 = ∑ t
=
t =1 (1+ RU ) RU
 Given that firm’s assets determine expected earnings (EBIT) & risk (RU),
does composition of financing alter total firm market value, or irrelevant?

MM Proposition 1-No Taxes to Start:

 Consider restaurant with + economic correlation: if equity holders fund all

assets, they bear all relevant risk & require turn R E = RU
 Any combo of debt & equity D+E must absorb the risk level RU
D E EBIT
 RU =WACC = RD + RE & V =
D+ E D+E RU
 MMP1: Any firm’s market value independent of capital structure & given
by capitalizing its expected return at rate appropriate to risk
 Unlevered Value = Levered Value: V U =V L
 How does leverage redistribute risk between debt & equity holders?
 Example -100% Equity Start-Up:
 Initial investment of 800, next year CF of 1400 & 900 (strong/weak
economy), both equally likely
 Systematic risk = premium needed of 10% over rf of 5%

 ECF 1 = ( 0.5 *1400 ) + ( 0.5 * 900 ) =1150

1150
 NPV =- 800 + = 200
1.15
CF 1 1150
 Sole equity financing: PVEqCF = = = 1000
1 + RE 1.15
 Unlevered Equity: firm financed 100% with equity; no debt:
EqCF = Project CF

 Shareholder returns = 40% / -10%; E ( RU ) = ( 0.5 * 0.4 ) + ( 0.5* 0.1 ) =15 %

 Since capital cost is 15%, shareholders earn fair risk-adjusted return
 Example-Mixed Financing Start-Up:
 Borrow 500 as well as raising equity, borrowing costs rf of 5%
 Payment Day 1 = 500 * 1.05 =525
 Levered equity holders get residual CF after deb paid; value is?
  Per MMP1, V U =V L = 1000 ( PVPCF ) = D + LEq= 500 +500

 Debt has 0 systematic risk, thus β = 0; under all scenarios,

likelihood debt doesn’t return 5% = 0 (risk-free); here,
LEq = 2 X UEqβ & 2 X Premium

MMP2 (No Taxes)-Risk Distribution

 D
 Expected return on LEq = UEq Return + Risk Premium: R E = RU + (R - R )
E U D

 Example 1: LEq Risk

 Assume for Example 1, borrow 700 when financing project, RUEq =
15% & rf = 5%; per MMP2 what will be firm’s equity cost?
D 700
 R E = RU + ( RU - R D ) =0.15 + * ( 0.15 - 0.05 ) = 0.3833
E 300
Mixing in Taxes, YAY:

 Consider unlevered firm having to pay tax rate Tc on earnings, firm value
EBIT *(1 - T ¿¿ C)
is PV of operating income: V U = ¿
WACC
 To increase value, firm can use debt to shield portion of earnings from tax,
since interest is deducted from EBIT before getting taxable income:
= EBIT - I - T
 Unlevered firm pays tax on EBIT, while levered firm pays EBIT-I,
incentivizing debt

MMP1-Now with Taxes & Debt:

 Compare 2 identical firms, one U, one L; leverage effect on investor-

available value?
 Leverage creates value by reducing taxable income, the interest tax
shield is savings from deductible interest
 Interest Tax Shield: IS = Tc * I = 0.3* 200 = 60
 Levered Firm Value: V L =V U + PVIS

 Interest reduces taxable income & thus taxes by 0.21 * 450 = 95 M

 Firm’s total value rises by shield value

 UCF Investors = LCF Investors + Interest Tax S h ield

 MMP Implications-Tax Benefits:
 Interest Tax Shield on Permanent Debt:
 Future interest varies by changes in outstanding debt, its interest
rate, firm’s marginal tax rate & obligation failure risk
 If firm keeps fixed permanent debt & Tc constant, then shield value
simplified
 PVIS = PV ( Tc * Future IPMTs )
 PVIS = Tc* PVFI
 PVISPD = Tc * D
 V L =V U + Tc* D
 Can also use WACC when finding PVIS
E D
 WACC = R + R * ( 1 - Tc )
D+E E D+E D
E D D
 WACC = RE + RD - R (1 - Tc)
D+E D+E D+E D

 Example 2:
 Project financed by new debt needs 5 annual I of 18M/year;
  Tc = 35%, debt costs 7%, & shield risk = loan risk, what’s the PVIS?
 IS = Tc * I = 0.35* 18 = 6.3 M
6.3 6.3 6.3 6.3 6.3
 PVIS = + + + + = 25.83 M
1.07 1.07 1.07 1.07 1.075
2 3 4

Capital Structure with Taxes in Reality:

 As to whether firms prefer debt, I’s tax deductibility makes debt attractive
external financing source, but in practice, a lot is internally financed
 Even without new equity, firms can grow as RE increases equity market
value, thus observed leverage reflects financing choices & firm value
changes over time
 Debt usage varies greatly across industries; high growth / uncertainty
lessens debt reliance, while mature / capital-intensive / regulated
industries oft more leveraged
 This is because taxes are paid after interest (T =( EBIT - I )*Tc); if I large
relative to EBIT, T may be low / 0, so firms needn’t rely entirely on debt to
get full tax benefits, but limits debt’s usefulness as shield

Week 7
Financial Distress, Default & Bankruptcy:

 Bankruptcy is important consequence of leverage, as equity financing

doesn’t have it; equity holders hope for dividends, but firm isn’t legally
obliged to pay them
 Process time-consuming, complex & costly, namely from outside
experts assisting
 Creditors also incur costs from waiting for payment, & may hire own
experts for legal & professional advice
 Average direct costs around 3-4% of pre-bankruptcy total asset value
 United Airlines’ 30+ advisors cost 8.6M/month in their Chapter 11
filing
 Enron’s 30M/month, totalling 750M
 Lehman Brothers’ total 1.6B over 2008-2022 process
 Indirect financial distress costs include customer, supplier, employee &
receivables losses, asset fire sales, inefficient liquidation & creditor costs;
estimated 10-20% FV
 Example of FDCs: Moon Industries
 FDC = 15M, rf = 4%, equal success/failure likelihood, β = 0;
securities value?
 ( 0.5 * 250 ) + (0.5 * 90)
 V U =UEq = =163.46
1.04
( 0.5 * 100 ) + ( 0.5 * 0 )
 LEq = = 48.08
1.04
( 0.5 * 150 ) + ( 0.5 * 75 )
 D= = 108.17
1.04
 V L = 48.08 +108.17 = 156.25 & Difference = 163.46 - 156.25 = 7.21
0.5 * 15
 EPVFDC = = 7.21
1.04
 When securities fairly priced , original shareholders pay PV of BC &
FDC
 Trade-off Theory: V L =V U + PVIS - PVFDC

 Agency costs arise from conflicts of interest in stakeholders, typically

between debtholders & equity holders, & managers & shareholders
 Levered capital structure can potentially (in)decrease agency costs,
but how are they measured, do they constitute a cash outflow, & if so,
who bears them?
 Equity holders don’t care about bigger losses once firm in range of CF
below face value of debt
 Main conflicts are wealth transfer (cashing out), risk shifting (asset
substitution problem), & debt overhang (underinvestment problem)
 Example-Wealth Transfer:

 Issue 50 debt (equally senior to existing), proceeds to repurchase

shares

Old DV = ( 0.5 *50 ) + ( 0.5 * 25 ) = 37.5


New DV = ( 0.5 * 50 ) + ( 0.5 * 25 ) =37.5


EqV = 0.5 * 50 =25

EqV + D = 25+ 37.5 = 62.5

Old Creditors ’ Loss = 50 - 37.5 = 12.5

Equity Holder Total = 50 +12.5 = 62.5
Equity gains = creditor loss; debt issuance dilutes existing

holders to the shareholders’ benefit
 Example-Risk Shifting:
  If firm already has debt & bankruptcy risk, equity holders gain
from rewards to risky projects & debt holders pay losses

 Suppose new investment opportunity of 0 cost & equally likely 5 /

-10 payoff

 NPV = ( 0.5 *5 ) + ( 0.5 *- 10 ) =- 2.5

 Investment destroys 2.5 value & transfers it to equity, debt loses

5; shareholders may want, debtholders likely don’t
 Example-Debt Overhang:
 If firm’s exiting debt “underwater” in some states, mightn’t be
able to raise equity for +NPV projects, as some returns
compensate existing creditors

 Suppose investment opportunity costing 10 & paying 15 in both

states
  NPV =- 10 + ( 0.5 *15 ) + ( 0.5 *15 ) = 5

 Investment raises D & E values at t = 0 by 7.5, but need initial

10
 Firm therefore unable to raise equity to finance +NPV project
 Partly explains why growth firms with volatile CF don’t use much
debt
 Rationalizes why some bankruptcy codes allow Debtor in
Possession financing to be senior to existing creditors (US
Chapter 11 filing)

Management VS Investors:

 Managers have own agenda for personal benefit, & interests that may
diverge from investor interests; conflict creates corporate governance to
negate agency costs
 Managers may reduce effort, avoid risks, divert funds to pet (-NPV)
projects, or steal
 Potential corporate governance solutions include BoD monitoring,
compensation & capital structure incentives
 Monitoring rarely done by small shareholders (limited incentive), thus
delegate to BoD, enhancing oversight via mechanisms like
independent auditors
 Lenders (banks) may also monitor for additional discipline layer
 Pay can align via shares, options, bonuses & required manager
investments
 May expose managers to risk beyond their control, & poorly
designed benchmarks may reward incorrectly
  Managers with major FCF access can pursue growth / acquisition
projects even when not maximizing investor value
 Debt can help via forcing payouts to investors, reducing excess FCF
& adding creditor monitoring when leverage is high
 Debt mitigates conflict between managers & investors by:
 Reducing equity market value, concentrating ownership &
strengthening large shareholders’ monitoring, & allows managers to
hold more meaningful equity stake, improving shareholder alignment
 Forcing managers to payout to investors regularly, reducing FCF &
limiting excess they control
 Creditors, when leverage high, can monitor more closely, adding
extra oversight
 Trade-off Theory: V L =V U + PVIS - PVFDC - PVDAC + PVDAB

Real Implications:

 CFO survey 2001-2022 for firms with sales > 1B & small firms, asking
about capital structure, planning, investment, payout, & governance
decision processes
 Does your firm have a target for how much debt to use?
 When considering appropriate optimal capital structure, what are the
primary measures used?

 What factors drive debt decisions?

  Why is maintaining financial flexibility important?

Week 8
Payout Policy:
 All cash distributions made by firm to shareholders (dividends & share
repurchases)

 Dividends reported as dividends per share (DPS), dividend yield (DPS/SP),

& payout ratio (DPS/EPS); level generally not fixed & paid quarterly
 Regular = expected maintenance, special = often one-time
 Important Dates:
 Declaration: Firm announces next dividend, record & payment dates
 Cum-Dividend: Last day shares traded with receipt rights (3d
prerecord date)
 Ex-Dividend: 1st day shares traded without rights (1d post-C-D / 2d
prerecord date)
 Record: Shareholders recorded by this date get dividend
 Payment: Dividend cheques mailed
 Example:
 RFC Corp. announced 1 dividend, if CDP is 50, what should first EDP
be under perfect markets?
 First EDP should drop by payment, thus = 49 (no arbitrage
pricing)
 Share repurchases are also returns of funds to shareholders
 Repurchased shares become treasury (issued, not outstanding),
excluded from outstanding count & meaningful stat calculations
 Premium oft offered to induce shareholders to sell (get CG & pay taxes)
 Repurchase Methods:
 Open-Market: Most common
 Firms announce plan, share count & period
 Buy back desired count via standard market transactions)
 Firms not obliged to buy stated amount, statement = maximum
repurchaseable
 Prices increase 2-3% on average when one occurs
 Tender Offer:
 Fixed Price: Firms offer to buy specified # at fixed price during
specific period
 If more tendered by holders than maximum offered, are
acquired pro rata
 If not enough tendered, firms can cancel repurchase
 Premium typically +20% market value, price rises 11% when
announced
 Dutch Auction: Firm specifies # & price range, holders bid P & Q;
repurchase price lowest, allowing firm to acquire desired number
 More discretion decreases premium to 13%, 8% average price
increase
 Targeted:
 Firm purchases directly from major holder; price negotiated,
mostly under these scenarios:
 Large holder’s sale can have significant negative impact, but
may be willing to sell at discount to market price
 Hostile bid by large holder, firm can try to kill threat by buying
them out at premium (greenmail transaction)
 Other Effects:
  Ownership Concentration: Repurchases increase ownership of
holders who don’t sell, helping to better align management
incentives
 Hostile Takeover Protection: Concentrating ownership makes
takeovers harder by repurchasing from holders that value them the
least
 Successfully signalling true value when undervalued increases
takeover costs & reduces likelihood
 Dividends VS Repurchases in Perfect Market:
 Pay now / later & dividends / repurchases: which best transfers wealth,
what are the practices & market reactions
 Example: Genron has 20M excess cash & 0 debt, expected additional
48 M
FCF of 48M/y, unlevered capital cost of 12%, EV = PVFCF = = 400 M
0.12
 Payout Options: Use 20M for 2 cash dividends for 10M holders,
repurchase, raise more capital to pay bigger dividend today
(anticipating more FCF) & in future
4.8
 Option 1: Pcum = CD + PVFD =2 + = 42 , Pex = PVFD = 40
0.12
 After stock goes X, price falls to reflect only future dividends
20 M
 Option 2: Genron repurchases = 0.467 M S h ares
42 / S h are

48 M 5.04
 Future DPS = = 5.04 ; Prb= = 42
9.524 M s h ares 0.12
 In perfect markets, open market repurchase has no price
effect
 Option 3: Assume planned payout = 48M next year & firm wants
to pay today; only has 20M cash today, needs 28M more to pay
bigger dividend now
28 M s h ares
 If raising more equity: could sell = 0.67 M S h ares
42 per s h are

 DPS =
28 M
10.67 M ( )
= 4.50 ; Pcum = 4.5 +
4.5
0.12
= 42
  Holding investment policy steady, dividend policy irrelevant to
firm value & share price (under MMP)

 MMDP & Irrelevance Intuition:

 Fixing investment policy, firm’s choice of policy irrelevant (no
initial share price effects
 Perfect world: no transaction costs & entry barriers, no tax
advantage to dividends VS CG, managers act in shareholders’
best interest, no information asymmetry, investment held
constant
 Intuition 1: Perfect market implies investors indifferent about how
they get money
 If investment fixed, must fix NPV so changing dividends
changes how money returns to shareholders
 Intuition 2: If firm’s policy fixed, shareholders can always
homebrew dividends
 If they want cash now & firm doesn’t pay dividends, can sell
shares
 If they want to keep investment but firm pays dividend, can
use to buy more shares
 Possible Payout Policy Determinants:
 Transaction Costs: High dividends reduce costs of homemade dividends
 Small investors who care about them may not be important (unclear
if they have meaningful policy impact)
 Taxes: Have important policy effect, as dividends & CG taxed
differently across borders; overall, tax preference for repurchases
 Holders must pay on dividends received & CGs when they sell
 Dividends typically taxed > CG; LT investors can defer by not selling
  Tax Disadvantages-Example: JRN Corp will pay constant dividend 3/y
forever; investors pay 20% tax (0 CGT), WACC = 12%
Dividend * ( 1- Td ) 3 * ( 1 - 0.2 )
 Price = = =20
rE 0.12
D 3
 Management announces repurchase instead: P = = = 25
rE 0.12
 Tax disadvantage = 5 difference
 Difference Across Investors:
 Income Level: Income level = tax brackets & different rates
 Investment Horizon: LT investors more heavily taxed, prefer
repurchases
 1y investors, pension funds & other nontaxed individuals
 Investor Type: Clientele Effect (Table)

 Signalling: Dividends communicate important information to markets;

implies firms increase when confident with LT earnings, & explains
smoothing & reduction reluctances
 If managers know more about firm than holders, dividends inform
markets & communicates that knowledge
 If less profitable firm pays big dividends, given low earnings, will
eventually have to: cut them & get flamed, lose investment
 opportunities from lack of funds, & issue equity/borrow to finance
them (uh oh, inefficiency)
 However, can signal optimism or lack of investment
opportunities; decrease can signal new potential +NPV
projects
 Signalling Method Efficiencies:
 Dividends most effective due to needing future commitments;
firm won’t start paying high dividends until they believe its
sustainable in LT
 Repurchases are strongest as fixed price tender; if shares bought
at premium & manager isn’t selling, firm is signalling shares
worth more
 Dutch auction weaker, but pay less for shares
 Open-Market have lowest price & weakest signal
 Agency Costs: Payout reduces money subject to managerial waste
(debt alternative)
 Dividends & repurchases leave management with less money for
poor acquisitions & -NPV projects (managers dislike, investors like)
 Payout policy is debt alternative for reducing FCF

 Payout VS Retention:
 With perfect markets buying & selling is 0NPV transaction, shouldn’t
affect firm value, retention VS payout decision irrelevant
 With imperfect markets, taxes paid by investors & corps may differ,
cash give firm -tax shield at corporate level
 To justify keeping cash, firm must show need to invest in +NPV
projects, offset by cash benefit of reducing expected FDCs
  Market Reactions to Dividend Changes:
 Announcements of changes: +0.73% & -1.19% AR for (in)decreases;
+1.01% & -6.35% AR for increases >25% & decreases <-25%;
+3.9% for initiation & -9.5% for omission
 Investors like when dividends started, hate when stopped; like
increases & dislike decreases (absolute fucking shock)
 Empirical Evidence:
 XD Price Changes & Taxes:
 Size of price drop on ED day (relative to dividend) depend on how
they & CGs taxed for typical investor
 On ED day, new buyers not entitled to upcoming dividend, so price
should fall

1 - Td
 General Formula: Pcum - Pex = D *
1 - Tg
 Linter’s Model of Dividend Payout: First payout policy model
 Pre-1980s; payout policy = dividend policy; decision concerned how
much to pay
 Formulated hypothesis from empirical observations with survey data of
28 listed, well-established US corps via interviewing 2-5 responsible
officials
 Key Observations:
 Firms don’t determine dividends as solution to optimization problem
minimizing its value
 Firms don’t set dividends independently each year based on its net
earnings, first decide whether to change dividends from previous
year, then its size
 Partial dividend adjustment: current dividend changes partially
depend on current net earnings changes
 Firms believe investors put premium on stable / gradual growth in
dividends, motivates firms to avoid changes that might be shortly
reversed, & believe stability minimizes adverse holder reactions
 Model Itself:
  Target Dividends: Dt = PR * EPSt ; 0<PR<1 & constant over time, but
differs between firms; target dividend varies with earnings:
*
∆ Dt = c + a ( D t - Dt - 1)
 D = dividend , a = adjustment speed (0 < a <1) , c = constant >= 0
 a & c constant over time, but differ across firms
 Restructured Model: Dt = c + a D* t + ( 1 - a ) Dt - 1
 a = weight on D*t (& EPSt) in finding D, a makes D partly
dependent on EPSt
 Greater a = more EPSt influence on Dt
 Lintner proposed a < 0.5, thus net earnings can vary yearly but
dividends relatively stable; past dividends more involved in
finding current dividends
 c is some unexplained autonomous amount of DPS, allowing for
reduction reluctance
 Worked well in 60s & 70s: a ≈ 1/3, c small & +
 Degraded in 90s & 00s (smaller a = dividend less responsive to
current net earnings, c < 0 dividend more likely to decline
 All explained by shift to repurchases in mid-80s

Week 9
Equity Funding Sources:

 Angel Investors:
 Individuals buying equity in small private firms
 Typically give first round of private equity financing
 Receive equity in new firm & ST convertible debt as compensation

Convertible notes change to equity on capital contribution, at initial

investment + accrued interest with (often 20%) discount
 Venture Capital Firms:
 Specialize in raising money to invest in young firm private equity
 Demand large ownership as compensation (common / convertible
preferred shares)
 Preferred shares get liquidation preference & board appointment &
other rights
 Benefits:
 Entrepreneurs get needed capital for growth
 VCs give expertise, mentoring & access on top of capital, as well as
credibility for future fundraising rounds
  Costs:
 Expensive as founders lose equity & control for money
 VC partners might take board seats & major holdings; may push
favorable decisions to their exit timelines over founder’s vision
 Stages:
 First: Build prototype, make manufacture plans & start financing
 Second: Subsequent financing for full ops, further additional rounds
 VCs limit risk via evaluation & incentivize management to
achieve milestones
 Institutional Investors:
 Pension funds, insurance companies, endowments & foundations
 May invest directly in private companies / indirectly via limited VC
partnerships
 Corporate Investors (Corporate / Strategic Partner / Strategic Investor:
 Established corps buying into young firms, motivated by strategic
objectives &/ investment return desires
 Example: Founded own firm 2y ago (100000) & 1.5M shares, sold 500K
shares to angels; now considering VCs investing 6M for 3M new shares
 PostMoney V = PreMoney V + Investment = 4 M + 6 M
Holder Shares 6M
 S h are Price = =2
Me 1500000 3M
Angels 500000  PostMoney Valuation =5 M *2 = 10 M
VC (New) 3000000 3M
Total 5000000  VC Owners h ip = =60 %
5M
1.5 M
 My Owners h ip = = 30 % ∨ 3 M
5M
 Exit Strategy: Investors in private companies need exit strategy for
investment liquidation
 Main Routes: Choice depends on market conditions, firm size & investor
preferences
 Acquisition: Company purchased by another; investors sell to acquirer
 IPO: Company sells shares to public; investors can sell on public market
 Primary Offering: New shares issued & sold, proceeds to company
 Secondary Offering: Existing holders sell shares, getting proceeds
 Underwriters: Investment banking firm managing IPO & designing
structure, lead underwriter taking most responsibility
 Give key services to companies making IPOs, acting as
intermediary between it & investors (sale method, pricing,
assistance); most cash offers involve them (big investment bank
venture)
  Paid via buying shares below offering price (offering – buying =
gross spread); bear risk on sale inability, thus create syndicate to
spread risk
 Syndicates: Group of underwriters helping market & selling issue
 Steps:
 BoD approval, registration statement prep & filing
 Distribute prospectus to potential investors
 Legal doc describing company & offer distributed in waiting
period during review (no sales)
 Once approved, determine price, issue final prospectus & start
selling
 Timeline: Usually 4-6m from decision day
 Preparation: Pick lead underwriter, form syndicate, do due diligence
 Filing: File registration statement(s) & respond to regulator’s
comments
 Marketing: Distribute preliminary prospectus & do a roadshow
 Roadshow helps underwriter log investor demand to inform price
 Pricing: Set offer price & allocate shares to investors
 Trading: Final prospectus issuance, then start trading
 IPO Puzzles:
 Underpricing where first day returns systematically positive
 Average 1960-2016, US aftermarket price 17% higher at end of
day 1 than offer price (VA Linux = 698%, Martha Stewart = 98%)
 Winners: Investors buying at offer price & selling Day 1
 Losers: Issuing firm if it raises capital < share value
 Existing holders see dilution at price below true value
 Explanations:
 Risk Compensation: Underpricing needed to attract investors
& compensate them for purchase risk (greater for younger
firms seen as riskier)
 Winner’s Curse: UIPOs oversubscribed & rationed; informed
investors crowd in, leaving uninformed more likely to get
overpriced shares
 To keep them in, IPOs must be underpriced on average
 Agency Conflict: Underwriters incentivized to ease issue to
sell & benefit investor clients
 Example: Firm IPO (2K existing shares, 124 true share value; offers
1K at 100, funds will go to 0NPV projects)
 New Equity Value= ( 2000 *124 ) + ( 1000 * 100 ) = 348000
 348000 116
 PostIPO Price = =
2000 + 1000 s
 Underprice Loss = ( 116 - 100 ) *1000 = 16000
 High issuing costs (direct & indirect)
 Direct: Underwriting fee paid via gross spread, filing/legal, taxes
& accounting costs; account for 10% funds raised (underwriter
discount often 7% issue price & quite large)
 Indirect:
 Management Time & Effort: Preparing IPO, roadshows,
investor meetings, legal prep & due diligence divert attention
from work
 Underpricing: Selling < true value implicitly borne by existing
holders, can be more than DCs (see 16% loss above)
 Combined DCs often 10% proceeds, 17% mean underpricing can
make effective cost >25% funds raised
 “Hot/cold” IPO market fluctuations due to things beyond capital
demand hot when firms & investors favoring them, cold when
opposite
 Possibly due to market timing with valuations, & investor
sentiment & optimism driving IPO demand
 Poor post-IPO LT performance of newly listed firms over 3-5y
 Might be from motivational conditions of IPO
 Possibly due to hot market/sector making mean reversion cause
underperformance, managers with better information issuing
when thought overvalued, & overoptimism fading with more
information
 Underwriting Types:
 Firm Commitment: Buys entire issue & assumes full sale responsibility
(most common); underwriter bears most risk (sell all shares or take
loss)
 Best Efforts: Sells as much as possible at agreed price, can return
unsold to issuer; risk stays with issuer
 Auction IPO: Auction off all shares, market determining price by bidding
on price & quantity (highest price with sufficient demand selected)
 Equity Issue Types:
 IPO: Initial offering/unseasoned offering; 1st public share trade
 SEO: Seasoned offering by public firm shares trading on public
exchange
 Process: Registration statement filing, prospectus, underwriter
engagement; price-setting unnecessary due to existing market price
  Market Reactions: News often greeted by 1.5% price drop due to
information asymmetry
 Mangers issue when stock believed overvalued, thus investors
view negatively), but still critical for more equity capital

Week 10
Mergers & Acquisitions:

 Corporate Control Market:

 Acquirer/Bidder = buyer firm, Target = seller firm
 Ideally, takeover market gives mechanism for corporate control to shift
to biggest value creators, thus M&A part of CCM

Form Description
Merger / 2+ corps combine & share resources; owners
Consolidation become joint & may form new entity
Share Acquisition Firm buys out target’s holders (target becomes
subsidiary)
Asset Acquisition Firm buys another’s’ specific assets
 Merger Types:
 Horizontal: Target & acquirer in same industry
 Vertical: Target’s industry sells to acquirer’s
 Conglomerate: Target & acquirer in unrelated industries
 Stock Swap: Target’s holders swap for stock in acquirer / merged
firm
 Term Sheet: Summarizes price & PMT method, who will run firm,
new BoD composition, HQ location, & new firm’s name
 Merger Waves: 60s-conglomeration, 80s-hostile takeovers & leveraged
buyouts, 90s-strategic/global deals under globalization, 00s-cross-
industry consolidation & private equity
 Takeover Market Reactions:
 Acquisition Premium: % difference between acquisition price &
premerger target price
 In most US states, law requires existing target holders get fair value
of shares if forced to sell
 Thus, acquirer likely to get target for < current value (oft premium)
 Acquirers pay mean 43% premium
 TH enjoy mean price gain of 15% on announcement
 Acquirer holders see mean 1% gain, half see decrease
 Why do acquirers pay premium, why does premium rise < acquirer
offer, & why doesn’t acquirer consistently get a price increase?
 Evidence indicates acquisition don’t always create acquirer
holder value (might be better to lose bidding war)
 LT M&A Effects:
 Acquirer’s buy & hold abnormal returns around -20% over next 5y
VS nontakeover matched firms
 In > 80% cases, merged firms worse than peers
 About 20% acquisitions 1980-1986 divested in 2y; over 10+y =
around 50%
 Strategic (timing) & integration failures (lack of post-acquisition
planning, culture, employee alienation, communication) cause
most failures
 Managerial Merge Motives: Private acquirer incentives may drive
destructive mergers
  Increased Power/Control: Larger firm size gives CEO more BoD
control
 Increased Compensation: Bonuses for successful takeovers
 Control Illusion: Most CEOs think market underprices firm
 Jealousy: CEOs follow peers into M&A
 Deal Heat: Excitement of merger process itself
 Interest Conflicts: Managers know they’re destroying value for
personal gain
 Hubris Hypothesis: Managers think they’re doing right thing
(overconfidence = overpaying)
 Merger Motives:
 Synergies: Large ones most common premium payment justification
 Cost Reduction: Most common & easiest; often cause layoffs of
overlapping employees & redundant resources elimination
 Revenue Enhancement: Harder to predict & get; depend on cross-
selling, market expansion, complementary products
 Scale Economies: Savings from making goods in high volume
 Scope Economies: Savings from combining marketing & distribution of
different types of related products
 Larger firms harder to manage, benefits must be > added
complexity & bureaucracy
 Vertical Integration: Merger of firms in same industry at different
production cycle stages
 Coordination of parts is beneficial, but not always sign of success
 Expertise: Helps to compete more efficiently
 New tech makes hiring experienced employees harder
 May be better to buy talent as functioning unit via acquisition
 Monopolization: Merging with rival may reduce competition & increase
profit
 Most countries have antitrust laws to prevent
 While all firms in industry benefit, merging firm pays costs
 Little evidence this even happens
 Efficiency: Acquirers oft argue they can run target better
 Often done via duplication elimination
 Finding poor performers is easy, fixing them isn’t
 Diversification
 Risk Reduction: Larger firms bear less idiosyncratic risk, often
justifying merger; investors can oft do this by buying shares in both
firms separately
  Debt Capacity & Borrowing Costs: Larger, diversified firms have
lower bankruptcy likelihood
 May increase leverage & get more tax savings without more
FDCs
 Gains must offset disadvantages from size & reduced focus
 Liquidity: Holders of private firms often have disproportionate share
of it, acquirer liquidity can incentivize target holder agreement
 Earnings Growth: Can combine firms so EPS > either’s premerger even
if merger creates 0 economic value
 Merging firm with little growth potential to high one can raise EPS
but adjusts P-E ratio accordingly
 Valuation & Takeover Process:
 Key issue is quantifying & discounting merger value-add; created value
= takeover synergy; Price for Target = Pre - Bid Market Cap + Premium
 To acquirer, takeover is +NPV project if premium < synergies created
 Once valuation done, acquirer makes tender offer (not all succeed, &
may require price increase to complete)
 Cash VS Stock Transactions:
 Acquirer can pay for target with either; cash includes any premium, &
stock swap gives new stock to TH
 Exchange Ratio: # acquirer shares received per target share
 Signalling Effects:
 If acquirer shares overvalued, may be best to use equity
 If undervalued, cash may be best to use
 Cash financing generally good news for acquirer, equity financing
show significant -LT performance
 Synergy Factors:
 High expected synergies, acquirer unwilling to share gains: cash
 Low expected synergies / high uncertainty: stock forces TH to share
pain
 Tax Implications: Cash triggers immediate CG liability for TH, swap
defers until holders sell new shares
 Example: NW has 1M shares at $100, earning $5M, OW has 1M shares
at $60, earning $5M; NW gets OW at market price via 600K shares
 EPS Effects:
 Post - Takeover Value = $ 100 M + $ 60 M = $ 160 M
 Total S h ares =1 M +600 K =1.6 M
Price $ 160 M
 = = $ 100
S h are 1.6 M
 $ 10 M
 Merged EPS = = $ 6.25 ( up || $ 5 )
1.6 M
 EPS increased $1.25 without economic value (share price =
$100); this is an accounting illusion
 Takeover Value Distribution:
 Evidence suggests acquirer premium about = added value, thus TH
capture most of the value they create (they may not even get any)
 Free Rider Problem: Target oft poorly managed (low share price)
 Corporate raider takes over & replaces it can increase firm value,
but current holders get value without contributing
 Example: Current Target Price = $45 (potentially $75), if raider
offers $60 current holders get $15, but another thinks they can get
$30 gain
 If all holders expect $75, none will tender at $60 & deal fails
 Success comes from offering $75+ (raider gets 0 profit & may
pull out)
 Worked Example: T has 10M at $50, A think it can increase value to
$60 (costs $3M); if A bids $51 each small holder faces: $51 tender /
$60 not if bid works, $50 regardless of tender if it fails
 Not tendering weakly wins, so deal fails (A must overcome FRP)
 Toehold Solution: A buys 10% toehold (1M at $50) in open market
first, then bids $60 for remaining 9M for $540M
 Owns 100% worth $600M; Profit = $ 600 M - $ 540 M - $ 3 M = $ 7 M
 2-Tier Solution: A pays high price for first block, once controlling
can force minority holders to take “fair” PMT ($53)
 Leveraged Buyout:
 Corp raider announces tender offer, borrowing to pay & pledging
shares as collateral
 If offer succeeds, gains control & attaches loans to corp,
effectively getting shares without paying directly
 Example: NIU has 20M at $40, 0 debt; raider can increase value
50%
 Radier borrows $400M for offer of 50% shares, adds it to firm
 Afterwards, total value = $1200M, equity = 1200-400 = 800M;
raider owns 50% equity for $400M indirectly
 Freezeout Merger: Situation where offer laws allow acquirer to freeze
out current holders by forcing nontendering holders to sell at offer
price
 Acquirer needn’t make cash offer, can use stock, beating FRP by
removing holdout option
  Takeover Competition: Once bid reveals significant gains, others may
bid too, causing “auction”; explains why acquirers pay large premia &
TH get most of the value

Tutorials & Exam Work

Reformulated Return on Equity:

Line Item / Calculation Source / Formula

Profit Before Taxes Original Income Statement
Income Taxes Original Income Statement
Profit After Taxes Original Income Statement
Effective Tax Rate IT
; both from OIS
PBT
Operating Income Before Taxes Original Income Statement
Operating Income After Taxes Original Income Statement
Lines Between Operating Profit & Original Income Statement
PBT
Net Financial Expenses Before Tax Incomes - Expenses
Net Financial Expenses After Tax NFEBT *(1 - ETR)
Net Operating Profit Margin OIAT
; Revenue from OIS
R
Net Operating Asset Utilization R
; NOA from RBS
NOA
Return on Net Operating Assets NOPM * NOAU
Net Borrowing Costs NFEAT
; NFO from RBS
NFO
Spread (Optional but may help?) RNOA - NBC
Financial Leverage NFO
: E from RBS
E
Return on Equity RNOA + FL*( RNOA - NBC)

Equity Valuation:

Line Item / Calculation Source / Formula

Constant Growth Rate Question Data
Net Operating Assets t Question Data
WACC Question Data
Operating Income After Taxes t+1 NOPMAT * Salest + 1
Residual Earnings-Operating Income OIAT
t+1
Firm Value REOI t + 1
NOA t +
WACC - g