Corp Fin Flashcards
Motives for merger
Create synergy Growth Increase mkt power Acquire unique capabilities Diversify (conglomerates) Bootstrap earnings (???) Manager personal incentives Tax savings Unlock hidden value Cross border motivation
Forms of integration
Statutory merger
Subsidiary merger
Consolidation
Industry lifecycle stages
- Pioneering development
- Rapid accelerating growth
- Mature growth
- Stabilization & mkt maturity
- Deceleration of growth & decline
Pioneering Development
Horizontal merger, Conglomerate
(Low but increasing sales growth, large development costs)
- Acquirer POV: Startups sell to large firms as new source of growth
- Target POV: pool/access to mgmt and capital resources
Rapid accelerating growth
Horizontal merger, Conglomerate
(High profit margins, low competition)
• Meet capital requirements for expansion
Mature growth
Horizontal, vertical
(Decrease in new entry, growth potential remains)
• for economies of scale, savings & operational efficiencies
Stabilization and mkt maturity
Horizontal
(Increasing capacity constraints, increasing competition)
- for economies of scale to match low pricing
- lg companies buy small companies to improve mgmt & financial base
Deceleration of growth and decline
Horizontal, vertical, conglomerate
(Overcapacity, eroding profit margins)
- horizontal mergers to ensure survival
- vertical mergers to increase efficiency & profit margins
- conglomerate mergers to exploit synergy
- may acquire growth from younger industries
Factors affecting choice of pmt
- if ACQUIRER believes merger to create value, push for cash offering
- if TARGET believes merger to create value, push for stock offering
Pre-Takeover defense
- Poison pills/puts
- Incorporate in state with restrictive takeover laws
- Staggered BoD
- Restricted voting rights
- Supermajority voting provision
- Fair price amendments
- Golden parachutes
Poison pills
(Pre-Takeover defense)
Grants right to issue stock options to existing shareholders with severely discounted exercise prices
Flip-in: gives target right to buy target shares
Flip-over: gives target right to buy acquirer’s shares
Dead hand: poison pill to be redeemed or cancelled by a vote of continuing directors
Poison puts
(Pre-Takeover defense)
Gives target BONDholders right to sell bonds back to target at above par value in event of takeover.
After takeover, acquirer needs to raise cash to refinance debt
Restricted voting rights
(Pre-Takeover defense)
Precludes shareholders who recently purchased large block of shares from exercising voting rights
Supermajority voting provision
(Pre-Takeover defense)
Target changes charter and bylaws to require higher % approval by shareholders for mergers (80% vs 51%)
Fair price amendments
(Pre-Takeover defense)
Changes to the corporate charger which only allows mergers with offer price > threshold
Golden parachutes
(Pre-Takeover defense)
Execs get lucrative payouts if they leave after chg in corporate control. Doesn’t deter, but pacify mgmt concerns abt job loss
Post takeover defense
- Just say no
- Litigation
- Greenmail
- Share repurchase
- Leveraged recap
- Crown jewel defense
- Pac Man defense
- White knight/squire defense
Litigation
(Post takeover defense)
Go to court for violation of antitrust or securities laws
Greenmail
(Post takeover defense)
Premium payoff to acquirer to terminate takeover (repurchase shares). There’s a 50% tax on acquirer’s profits
Share Repurchase
(Post takeover defense)
Raises share price
Leveraged recap
(Post takeover defense)
Issues lg debt to repurchase shares
Crown Jewel
(Post takeover defense)
Sells off valuable asset to make firm less attractive
Pac Man
(Post takeover defense)
Target attempts hostile takeover of acquirer (rare)
White knight
(Post takeover defense)
Encourages 3rd firm to acquire target (more acceptable to target mgmt)
White squire
(Post takeover defense)
3rd party purchase substantial minority stake (large enough to block takeover)
Risk of litigation here
Herfindahl Hirschman Index (HHI)
Post merger HHI:
Less than 1000, not concentrated
1000 to 1800, moderately concentrated
More than 1000, highly concentrated
Post merger HHI:
Less than 1000, (any amt, no action)
1000 to 1800, (100+ chg, possible challenge)
More than 1000, (50+ chg, challenge)
Basic forms of restructuring
Equity carve out
Spin-off
Split-off
Liquidation
Equity carve out
Company splits 1 of divisions to create new entity and offer shares to outsiders (cash inflow)
the ex-parent usu maintain some control of the business split out
Spin-off
Separates 1 of divisions to create new entity but shares are proportionally issued to current shareholders
Split-off
Separates 1 of divisions to create new entity and offers current shareholders shares in new entity in exchange for parent
2 objectives of corp gov
- Eliminate conflicts of interest
2. Ensure company assets are used in best interest of investors & stakeholders
Effective corp gov system has:
- Clear description of RIGHTS of shareholders and stakeholders
- Defines responsibilities of managers and directors to stakeholders
- Identifies measurable accountabilities for performance
- Ensures fairness and equitable treatment in all dealings b/w managers, directors and shareholders
- Ensure transparency and accuracy in disclosures of operations, performance, risk, financial position
BoD has responsibility to:
- Establish corporate values and governance structures for ethical, competent, fair and professional conduct
- Ensure all legal and regulatory requirements are met, complied with fully and timely
- Establish LT strategic obj for company with goal of ensuring the best interests of shareholders served
- Establish clear responsibilities and accountability system & performance measurement in all ops
- Here CEO, determine comp package & periodically evaluate officer’s performance
- Ensure management has supplied board with sufficient info to be fully informed & prepared to make decisions
- Meet freq enough to adequately perform duties & meet in extraordinary session as required by events
- Acquire adequate training so members are able to adequately perform duties
Staggered boards are good/bad for corp gov?
Good, allows continuity of knowledge & experience
Stakeholder impact analysis (SIA)
- Identify stakeholders
- Identify stakeholders interests & concerns
- Identify what claims stakeholders are likely to make on org
- Identify stakeholders most important to org
- Identify resulting strategic challenges
Philosophical approach to ethics
- Friedman doctrine
- Utilitarian ethics (majority rules)
- Kantian ethics (ends rather than means)
- Rights theories (fundamental rights)
- Justice theories (equal dist)
Dividend irrelevance theory (dividends don’t matter)
Homemade dividends
Bird in hand (dividend matters)
Prefer current dividends over equal amt of potential capital gains from reinvesting earnings (uncertainty)
Tax argument (dividend matters)
Higher tax on dividends than capital gains means preference for reinvesting earnings
Dividend imputation system
Dividends taxed ONCE @ shareholder’s MTR (Australia, New Zealand, France)
If investor’s MTR is lower than CTR, a tax credit is received
Otherwise pay additional taxes
Split rate tax system
Earnings distributed as div are taxes lower than earnings retained by company. Div taxed again at shareholder lvl.
3 dividend policies
- Stable
- Constant
- Residual
Stable dividend policy
Companies seek to increase dividends each year at a constant rate
Constant dividend policy
Keep constant dividend payout ratio
Dividends will vary with earnings, more volatile and a higher risk premium attached
Residual dividend policy
1st use internally generated funds to finance investments in positive NPV projects consistent with target capital structure
Remaining funds distributed entirely as dividends
Pros of share repurchases
Potential tax adv Share price support (positive signal) Managerial flexibility Offset earnings dilution from employee stock options Increase financial lvg
Rises when company is strong and falls during recessions
Effects of share repurchases
If borrowed funds are used to finance repurchase:
the after tax Rd > earnings yield, EPS FALLS
the after tax Rd
Effects of share repurchase on BV
When mkt price > BVPS, BVPS FALLS after repurchase
When mkt price
Jensen’s FCF hypothesis
Managers endowed with FCF will invest in negative NPV projects rather than pay to shareholders
So dividends and debt can mitigate the over investment agency issue
MM1 (w/o taxes) : capital structure irrelevance
VL = VU
- Investors have homogenous expectations of CF from bonds & stocks
- Capital mkts are perfect (no taxes, transaction costs, bankruptcy costs) symmetric info, same stuff, same price
- Borrow & lend at rf rate
- No agency costs, managers act in shareholder’s best interest
- Financing & investment decisions independent of each other (op income unaffected by capital structure)
MM2 (w/o taxes): higher financial lvg raises Re
Re = Ro + (Ro - Rd)*(D/E)
The cost of equity is a linear function of the company’s debt/equity ratio
MM2 (w/o taxes): equity beta
Beta(E) = Beta(A) + [Beta(A) - Beta(D)]*(D/E)
Equity beta increases as D/E ratio increases
MM1 (with taxes)
VL = Vu + (D)*(t)
With taxes, and no costs of financial distress & bankruptcy, debt offers tax benefits.
Value of company increases when more debt is issued
MM2 with taxes
Re = Ro + (Ro - Rd)(1-t)(D/E)
Company value increases when more debt is issued
Agency Costs
- Monitoring costs (10-k, BoD)
- Bonding costs (explicit, implicit) non-compete contracts, insurance for performance guarantee
- Residual loss: costs incurred despite monitoring & bonding
Higher debt limits opportunities for mgmt to misuse cash
Pecking Order theory (costs of asymmetric info)
Managers prefer modes of financing that offer lease info content to outsiders
Debt issuance: positive
EQ issuance: negative
Costs of asymmetric info decrease as more debt is issued
Static-Trade off theory (optimal capital structure)
After Acctg for costs of financial distress,
VL = VU + (t)*(D) - PV(costs of financial distress)
International diff in capital structure
France, Italy and Japan use more debt than US, UK
Namerica use more LT debt than Japan
Developed mkts use more LT debt than emerging countries
Countries with weaker legal systems have higher financial lvg and more use of ST debt
Effects of inflation on capital budgeting
Higher than expected inflation:
• increases real taxes, by reducing value of depreciation tax shelter (unless tax system adjusts dep for inflation)
• decreases real interest exp
Expected inflation & WACC
Increase in expected inflation will increase WACC
2 methods for finding NPV of mutually exclusive projects with unequal lives
- Lease common multiple of lives approach
2. EEM
NPV vs IRR
Independent projects: NPV & IRR same results
Accept positive NPV & IRR>cost of capital
Mutually exclusive projects: NPV & IRR differ. NPV best, realistic reinvestment rate assumption @ required rate of return
IRR: assumes interim CF reinvested at IRR
Capital Rationing
Start with highest PI to lowest
Sensitivity, scenario & Monte Carlo analysis
- Sensitivity: 1 input variable at a time
- Scenario: multiple variables
- Monte Carlo: simulation
Greater the dispersion of NPV, higher the risk
Monte Carlo analysis
Estimate probability distribution of outcomes for project NPV & IRR
Define prob dist for input variables instead of point estimates in scenario analysis
Run simulation thousands of times to get distribution for possible NPV & IRR
Inputs: assumed distribution & mean/std
Positive skewness: skewed to the right
Diff between Acctg and economic income
Acctg depreciation: based on original cost of investment
Economic depreciation: based on MV asset
Interest Exp: subtracted from Acctg income, not considered in economic income (implicitly in required rate of rtn)
3 diff valuation approaches in capital budgeting
- Economic profit/WACC
- Residual income/Re
- Claims valuation/Rd, Re separate
All should lead to the same value
4 Risks
1) Asset risk
2) Liability risk
3) Financial disclosure (acctg risk)
4) Strategic policy risk
BoD best practices:
Composition of Board
75% of board members are independent
BoD best practices:
Chairman
Independent
Chairman CEO
BoD best practices:
Election
Annual re-election
BoD best practices:
Meetings
requires independent board members to meet in separate sessions AT LEAST annually; qtrly is preferrable
Corp Gov best practices:
Audit Committee
1) Audit comittee should consist of independent directors.
2) At least 2 members should have relevant acctg & auditing experience
3) Internal audit staff should report to audit committee directly
4) committee should meet with external auditors at least once annually w/o mgmt present
Comparables vs Comparable Transactions
Comparables: need to include control premium
Comparable Transactions: control premium included in multiple already
