401 - EXAM 2 Flashcards
Company valuation slides
want to value for M&A
- -how much to pay for acquisition? - what merger terms are fair to shareholders? - what price do we demand for our company from an acquirer?
- -is current stock price accurate measure?
- DCF analysis
- Comparables (CF based multiples or asset-based)
DCF analysis
calc. terminal value under one of 2 assumptions:
1. company is liquidated
2. remaining FCFs can be valued as a perpetuity
- LIQUIDATION SCENARIO
Sale of existing assets:
–calc. CF that firm receives from liquidating assets (resale value)
–account for tax consequences
RV - (RV-BV)*t
recapture of NWC
–NWC at their PV at selling date (year 5 for ex.) - then find PV of that CF today
- TV AS A PERPETUITY
–forecast all FCFs then PV of TV found from GGM
(bounds for LTG - must be higher than inflation to be profitable (>2%) and less than nominal GDP (<5%)
Other method of finding TV
- -using COMPARABLES
- -find earnings or BV in year T and use an appropriate P/E or mkt. to book ratio to value continuing operations
or another alternative to calc. TV is the BV of assets at the end of the forecast horizon
(ON NEXT TEST!!)
DCF analysis pros/cons
PROS
- -CF comes from specific forecasts and assumotions
- -can see impact of changes in strategies
- -valuation tied to underlying fundamentals
CONS
- -CF only as good as your forecasts/assumptions
- -might “forget something”
- -much of value comes from TV
- -you have to come up with the correct discount rate, based on a theory (CAPM) which might not be correct or precise
CF rules
only look at project INCREMENTAL CFs
- -only look at changes in CF directly attributable to the project
- -ignore sunk costs
- -include OPP. COSTS
- -allocated costs included only after careful thought
- -excess capacity should be included only if its an actual cost to the whole company
when in doubt, remember the with-without principle
–imagine 2 worlds, one with the project and one without - any CFs diff. in those 2 worlds are relevant
LOOK AT EXAMPLES OF WHICH CFs to include!!!
DCF analysis slide 7 has lots but no answers
CF rule $2-4
DISCOUNT nominal CFs at NOMINAL discount rates
- -may project real CFs but discount by real rates
- -just be consistent in how you treat inflation
- -nominal discount rates reflect inflation in overall economy - but inflation in indiv. cash flows may be diff. (but some items like depreciation have no inflation)
3 - after tax CFs (FCFF formula)
- do NOT include fin. costs in Bfs
- -financing costs accounted for in the discount rate
- -deducting int. expense from CFs would be double counting
term clarification:
- -salvage value
- -resale value
- -book value
SALVAGE VALUE
- -value to whcih an asset is fully depreciated using straight-line depreciawtion
- -salvage is not resale value - bc straight line = (IO - salvage) / number of years
RESALE VALUE
–value for which we can expect we can sell an asset at the end of its life
BOOK VALUE
- -value of the asset on books - intial cost less accumulated depreciation
- -when an asset is fully depreciated, the BV = 0 (using MACRS) or will equal the salvage value (using SL)
MACRS = modified accelerated cost recovery system
REMEMBER THE RESALE VALUE BOOK VALUE FORMULA!!!
Fin. innovation and the fin. crisis
MOST imp. ppl are institutional investors (hold all money and invest it)
- -RUNNING analogy - off pace so have to make up speed at the end to meet your time goal
- -so the isntitutional investors take $ to provide for ppl LATER when they retire –> but they are ASSUMING where yields and int. rates will be 40 years later –> so they invest…but if yields go LOWER than expected —they don’t have all the money they owe (so turn to VC (sprinting at the end) to make up with higher returns)
LOOK UP TRONCHES - in Crisis - easier to get loans on homes so gave out loans to ppl who were not credit worthy
- -mortgage backed securities - took all the mortgages and invested assuming sub-prime borrowers would hvae UN-CORRELATED defaults
- -issued mortgages to more ppl knowing (10/30) would default - so took on more risk at higher rates so they could pay back the institutional investors who were “behind pace”
clients needed more YIELD so the house prices went up - bc more mortgges so more $ in mkt. but in places like SF/vegas they didn’t build more houses so S constant bu D increasing so prices rise
why banking system exposed to house price risk?
the banks were financing themselves with REPOS - repurchase agreements
- -ex. he is going to Vegas and has car worth $11,000 - sells to someone for $10k promise to buy back Mon. for $11k - confident he will earn enough and guy will enter repo bc collateral has value - can sell either way bc earns $10000 - he needed liquidity quickly so sold his asset
- -collateral for banks was mortgage-backed securities - how they were financed - Goldman and Lehman Bro. - Goldman was able to refinance themsevles…Lehman died bc financed to aggressively
next exam - talk abobut what to do with the $
should firm give out more div. or repurchase??
–shares undervalued –> repurchase shares –> signals
ASSUME
1. WORLD WITH NO ASYMMETRIC INFO.
2. no taxes - buy back for tax shield
concentrates EPS —> Inc. firm value
–look at the pictures of the Asset box on left and D/E –> just shrink your equity when repurchase and therefore your assets…so more Leverage used to finance assets = lev. inc. and EPS inc. –> have not increased value…just have amplified earnings - INC risk
EPS = NI/# shares
Argument for and against div. payout or share repurchase decisions - inc value??
M&M says it doesn’t
- -do shareholders have preference btwn dividends and repurchases?
- -undeer M&M assumptions they don’t - but we live in a world with asymmetric info. and taxes!!
ex. firm has 10 shares @ $10 each 9firm value = $100)
- -has $10 to distribute
- -div. = pay $1 to each shareholders = $10 —> firm value falls to $90 —> so each shareholder EPS = 90/10 = $9 + $1 in cash from div. = $10 EPS
- -or use $10 cash instead of payout to repurchase shares –firm value = $90 –> 90/9 shares = $10 EPS –>SAME!!
Argument for and against div. payout or share repurchase decisions - inc value?? – CONTINUED
GGM - firm value growing as your Div. (CFs) are INCREASING - if repurchase – can reinvest and create more growth and CFs in the future
–OK to not pay dividends if investors expect higher return later on - would rather reinvest in comp. than elsewhere if give them higher return than alternatives (cap. gains if not receiving dividends)
M&M - gets us to ask question – what frictions exist in the real world so that a dividend or repurchasing agreement would affect firm value??
M&M - gets us to ask question – what frictions exist in the real world so that a dividend or repurchasing agreement would affect firm value?? (1)
GRADE trading example – only the bad cards willing to trade - knew exactly who had them bc of who was trading
- ASYMMETRIC INFO problem - actions send signals
- -repurchase = show company thinks shares are undervalued - or signal that they don’t have a current project to use the repurchase cash elsewhere
- -BC of asymemetric info!! –> div. payout and repurchase agreement CAN impact firm value
signals paying div.
- -could show stability of CFs – times are good
- -could show excess cash –> they are not working on profitable projects where they coudl utilize that cash
- -issuance - buy high - shows they need quick funding
M&M - gets us to ask question – what frictions exist in the real world so that a dividend or repurchasing agreement would affect firm value?? (2)
- TAXES
–dividend recap - if all equity financed – could take on more debt to buy back shares and take advantage of tax shield
TAX SITUATION
–dividends –> taxed on ordinary income
–repurchase –> capital gains
–tax rate on dividends is higher than the tax rate on capital gains
-ex. NI = $100, 100(1-.4) = div. –> 100(1-.2) = cap. gains
tax advantage is BETTER on capital gains than dividends (cap. gains tax dec. to encourage investment to inc. economic activity)
company would DEC. value if they chose to pay dividends over repurchasing bc the tax rate on ordinary incoe is HIGHER
–repurchases send a stronger positive signal than dividend
WHY PAY DIVIDENDS???
–bird-in-hand hypothesis
Capital mkts. aren’t perfect –> investors don’t undersand paying dividends is impractical
PUZZLE - WHY PAY DIV?
- what is value in paying cash to investors?
- why are div. preferred to repurchases or simply selling stock?
BIRD-IN-THE-HAND hypothesis
- -div. today is safer than promise of future pmts. (cap. gains)
- -investors will pay a premium for div. paying firms (does it inc. firm value?? THOUGHTS ON THIS THEORY??
- -div. increase firm value (assumptions of div. pmts. for firm valuationP)
- -AGENCY COST PROBLEM - use $ to indirectly benefit themselves
Clientele hypothesis
some investors naturally have a stronger preference for receiving dividends
- -pay premium for div. paying firms - so does this inc. firm value?? THOUGHTS
- -retired ppl - ppl who div. is INCOME (stable, consistent CFs) - does not really help bc div. taxed higher –> so gain more by buying low selling high (cap. gains) –> but irrational thinking keeps comp. paying dividends
selling shares > rec. interest
also liquidity problem (smaller, private firms)
–usualyl corp. do not have liquidity problems - so wy paying value destroying dividends? - bc taxed so high??? - no answer - puzzle
FCF hypothesis
agency conflict - managers know more about earnings than shareholders
- –so shareholdlers do not trust mgmt. to spend excess cash wisely - so prefer that mgmt. pay out cash as dividends before they misuse it - thoughts on theory?!!
- -paying div. is credible sign that firm is stable and growing (but this sigals less than repurchase argument - cap. gains)
what are you trying to accomplish - is thre a beter way to do this? ex. give $ to shareholders
READ IN BOOK!!
Three ways to repurchase shares
1. OPEN MARKET PURCHASE
- open market purchase
- -firm buys its own shares on market
- -not very strong signal but company calls broker and no one really knows about it (can just secretly buy them back)
Three ways to repurchase shares
2. FIXED PRICE TENDER OFFER
- FIXED PRICE TENDER OFFER
- -Firm offers to buy up to a pre-specified # of shares at pre-specified price during pre-specified period of time
EX. XYZ announces it will buy 200,000 of its 5M shares @ $28 per share
- -always offer to buy a price WAY higher than current share price (repurchase –> cap. gains)
- -if 100,000 shares tendered XYZ buys all
- -400,000 offered, buys 1/2 shares tendered by each . shareholder
Three ways to repurchase shares
3. DUTCH AUCTION
- DUTCH AUCTION
- -Each shareholder is invited to submit bid price at which they are willing to tender (sell) their shares
- -repurchase price is lowest price necessary to acquire # shares they want all at ONE PRICE = all the same
ex. 50,000 shares tendered @ $25
- -150000 @ $26
- -80,000 at $27
so if want to repurchase 200,000 - will buy 150000 at $26 and 50,000 at $26 (SAME PRICE)
LOWEST PRICE NECESSARY TO ACQUIRE # SHARES SOUGHT
Finding market value of firm
Mkt. value of firm = all equity financed + PV(Tax shield) - P(d)*L.G.D.
- -P(D) - found by finding the credit rating
- -LOOK AT THE GRAPH PICTURE - the parabola to find the optimal capital structure
- -can look to see which region we end up in
V = D * T
V = $380B –> V firm inc. by $380 B (be sure to look over all of the recent problem sets)
–on the graph, our value (Y axis –> increased up to $380B) - but where ar we on the parabola/line? - if too far beyond maximum on parabola…we took on too much debt bc P(D) too high now
–the value is added bc of the tax shield by taking on debt to finance the repurchase
1. at time of announcement P could inc. or
2. after repurchase
–consider types of repurchase –> this assumed it is an OPEN MKT. repurchase bc we use new mkt. price to buy shares
to find the credit rating –> make assumption w/ certain rating - test out all ratios and see if it compares to ratios of similar tates comp. - if not try new ones!!
-also consider legal expenses which dec. rating bc high expense that INC P(D) –> if decide btwn A/A+ rating…then google P(D) for A+ rated bonds in 1998 = .0018
Vfirm = 6.58B + 380M - .02 *(L.G.D) 6.58 = mkt. cap tax shield = 380 P(D) = .02 - from credit rating diff. to calc. L.G.D. but know it would have to be about (380*5) = 19B to outweigh the tax shield...so very unlikely!!
THIS IS ALL UST - MAKE UST NOTECARDS AFTER! (10/25 notes)
Calc. L.G.D. (UST)
can’t calc. L.G.D. but can make qualititative estimate
- -with capital structure check list
- -dependent on external funds?
- -comp. threats? - in UST it was low bc of barriers to entru in the market (means L.G.D. is low)
- -tax rate high enough for tax benefits?
- -customers care about distress? (No = L.G.D. dec.)
mortgage interest pmts. are tax deductable - SO GOOD - why the rich still have mortgages
- -bc comp. (UST) is super rich – can take on debt to get tax benefits…but even if income fails, have so much cash they can just pau off the debt (mortgage) by liquidating assets
- -also should have considered legislation and litigation –> lawsuit $1B should be another LIABILITY
- -litigation threat decreases their value
FOOTNOTE – AGENCY THEORY EVIDENCE (misusing funds)
WACC class
R = P1/P0 - 1, so if P dec. then R inc. - inverse relationship
Qualtrics issued $100M (D&E)
- -trade off theory – tells us how to find optimal capital structure
- -D&E –> 67% E and 33% D - cost of debt = 5% interest
- -the req. return on equity inv. = 10%
WACC = approx. 7.5%
- -if don’t make MORE THAN 71/2 M…then DESTROYING ECONOMIC VALUE (not making profit)
- -means they have assets that cost hem more than they are making - it is an opp. cost and money could generate value if used elsewhere
- -if goes too far..can’t make debt pmts. and leads to bankruptcy
