CORPORATE FINANCE

Question 1

Is the US public corporation in trouble?
Kahle, Kathleen, Stulz, 2017

Describe the development of the number of public firms

Answer 1

The number of listed firms increases rather steadily until 1997. After that, the number starts decreasing and a “listing gap” develops (fewer firms than expected). By 2012, the predicted number of listed companies is more than double of the actual number.

(today: PREDICTED # > ACTUAL #)

Question 2

Is the US public corporation in trouble?
Kahle, Kathleen, Stulz, 2017

What are 2 reasons for decrease in the number of public firms?

Answer 2

1. Low numbers of newly listed firms

2. High numbers of delists

Question 3

Is the US public corporation in trouble?
Kahle, Kathleen, Stulz, 2017

What are 3 reasons for a firm to delist?

Answer 3

1. firm no longer meets the listing requirements (due to financial distress)
2. it has been acquired ( mergers are the dominant reason for delisting)
3. it voluntarily delists

Question 4

Is the US public corporation in trouble?
Kahle, Kathleen, Stulz, 2017

What are 2 ways to measure a firm’s age?

Answer 4

1. from the date of incorporation (lacking in databases)

2. from the date the firm went public (downward biased)

Question 5

Is the US public corporation in trouble?
Kahle, Kathleen, Stulz, 2017

Is aging trend more dramatic in public or private firms? Why could it be bad?

Answer 5

• Aging trend is more dramatic among public firms than private firms
• There is evidence that older firms innovate less and are more rigid.

Question 6

Is the US public corporation in trouble?
Kahle, Kathleen, Stulz, 2017

What is Tobin’s q?

Answer 6

The market value of a company divided by its assets’ replacement cost.

Question 7

Is the US public corporation in trouble?
Kahle, Kathleen, Stulz, 2017

Have firms become larger or smaller since 1997? What about the concentration of firms?

Answer 7

Much larger (increase by 290% in market capitalization).
Also, more concentrated (industries are on average much more concentrated now than 20

years ago, but less than 40 years ago)

Concern with fewer but larger firms is that concentration within industries can increase, which could possibly badly affect competition (difficult to enter the
market for small firms)

Disclaimer: Te bija daudz skaitļu, kurus neliku, jo nav vajadzīgi, manuprāt

Question 8

Is the US public corporation in trouble?
Kahle, Kathleen, Stulz, 2017

Describe investment trends of public firms nowadays

Answer 8

The INCREASE in the importance of INTANGIBLE ASSETS: listed firms have a much lower average ratio
of capital expenditures to assets and a much higher ratio of R&D expenditures to assets in 2015.

Overall, INVESTMENT is SMALLER (Total investment peaks at 17.5% in 2000. In 2015, it is only 11.6%)

Question 9

Is the US public corporation in trouble?
Kahle, Kathleen, Stulz, 2017

Describe public firm’s balance sheet development

Answer 9

INVENTORY has been FALLING due to the introduction of just-in-time production processes (firms receive
goods only when needed).

LOWER LEVELS OF FIXED ASSETS

MORE CASH - especially for R&D expenditures

Question 10

Is the US public corporation in trouble?
Kahle, Kathleen, Stulz, 2017

What is the concern about balance sheet of a public firm with respect to investment in intangible assets

Answer 10

Investments in most intangible assets are not
recorded on firms’ balance sheet, thus, a firm’s balance sheet becomes a LESS INFORMATIVE measure

of the firm’s financial position

Question 11

Is the US public corporation in trouble?
Kahle, Kathleen, Stulz, 2017

Briefly describe the profitability of public corporations

Answer 11

Larger firms have a higher ratio of cash flow to assets, meaning firms have been performing POORLY on average, except for the largest firms.

Why so?

• the fraction of firms with negative net income increases over time
• rise of R&D spending (R&D is expensed not capitalized)

There has been dramatic increase in the concentration of the profits and assets of US firms - top 30 firms earn 50% of the total earnings of the US public firms.

Question 12

Is the US public corporation in trouble?
Kahle, Kathleen, Stulz, 2017

Why is R&D difficult to finance with debt?

Answer 12

The VALUE of R&D in process is HARD TO MEASURE by creditors.

Fixed assets provide collateral but no R&D activites

Question 13

Is the US public corporation in trouble?
Kahle, Kathleen, Stulz, 2017

What is the evidence of decreased leverage of public firms?

Answer 13

1. leverage falls dramatically for an equally weighted measure of leverage
2. asset-weighted book leverage ratio rises but drops sharply after the financial crisis
3. ONLY IMPORTANT POINT - “net leverage ratio” (debt minus cash over total assets) - falls steadily and in almost all years since 2003, the average public firm has more cash than debt.
4. & of listed firms without debt increases.

Question 14

Is the US public corporation in trouble?
Kahle, Kathleen, Stulz, 2017

What are the main forms of debt now for public corporations? What is less popular?

Answer 14

Debt can be in the form of either publicly traded debt such as bonds, or private debt such as bank debt, whereas bank loans have become less important.

In addition to debt, firms issue equity to finance themselves. Smaller firms tend to issue more
equity than they buy back, whereas larger firms buy back more shares than they issue.

Question 15

Is the US public corporation in trouble?
Kahle, Kathleen, Stulz, 2017

Describe institutional ownership trend of the public companies

Answer 15

Institutional ownership of common stock is much higher now. Institutions tend to prefer large firms.

It is now much more common for a firm to have an institutional investor who controls 10% or more of the shares (the percentage of US firms with a 10%
institutional shareholder has increased more than twice in the past 40 years).

Question 16

Is the US public corporation in trouble?
Kahle, Kathleen, Stulz, 2017

Describe the current agency problem (in theory) of public corporations. Does it hold?

Answer 16

Agency problem of free cash flow: managers of public firms often retain earnings (payout rates
are too low) even when they cannot reinvest them profitably, which destroys shareholder wealth. (e.g. because of R&D project expansion)

The theory does not hold, because evidence says that the payout rate (dividends plus repurchases as a fraction of net income) is at an all-time high in 2015.

Question 17

Is the US public corporation in trouble?
Kahle, Kathleen, Stulz, 2017

Why is the payout rate so high nowadays?

Answer 17

1. Perceived lack of investment opportunities

2. Reduced incentives of firms to invest

Question 18

Is the US public corporation in trouble?
Kahle, Kathleen, Stulz, 2017

What is the trend with share repurchases?

Answer 18

Over the past 40 years, share repurchases have increased considerably.
Stock repurchases are at record levels in the 2000s and extremely high in recent years.

Question 19

Is the US public corporation in trouble?
Kahle, Kathleen, Stulz, 2017

What is the implication with regards to acquisitions?

Answer 19

Reallocation of resources naturally leads to consolidation: less-efficient firms are acquired by more-efficient firms.

BUT if consolidation has nothing to do with being a public firm, we should see the total number of firms decreasing. In reality, only the number of public companies decreases.

Question 20

Is the US public corporation in trouble?
Kahle, Kathleen, Stulz, 2017

What could be possible explanation for decreasing number of public firms? Is it true?

Answer 20

Regulatory burden associated with being public has
increased.

However, it is only part of the explanation, as:

1) drop starts before regulatory changes
2) more firms are delisted because of mergers than went private

Question 21

Is the US public corporation in trouble?
Kahle, Kathleen, Stulz, 2017

Explain 7 reasons why the fraction of small public firms has decreased

Answer 21

1) firms DON’T WANT TO DISCLOSE their PROJECTS to large investor audience and potential competitors (a process that is generally required to attract equity investors)
2) public markets have become dominated by INSTITUTIONAL INVESTORS (small firms don’t have
enough scale for their investment and receive less attention)
3) developments in financial intermediation and regulatory changes have made it EASIER TO RAISE FUNDS AS A PRIVATE FIRM (from PE and VCs)
4) economies of scope hypothesis: small firms have become LESS ABLE TO GROW ON THEIR OWN.
better off selling themselves to large organizations that can bring a product to market faster and realize economies of scope (think Mailigen)
5) INCREASED CONCENTRATION could also make it harder for small firms to succeed on their own
6) increased importance of INTELLECTUAL PROPERTY makes it difficult for small firms to grow without acquiring patents
7) it has become EASIER to PUT a NEW PRODUCT ON THE MARKET without hard assets. Via renting & outsourcing, capex is smaller and no need to go public & raise large amounts

Question 22

Capital Structure
Myers, Stewart, 2001

Describe Modigliani & Miller theory

Answer 22

If we live in perfect capital markets, the choice between EQUITY AND DEBT financing is IRRELEVANT- no material effect on the value of the firm or on the cost or availability of capital.

In the real world, the financing choice does matter because of taxes, difference in information, agency costs

Question 23

Capital Structure
Myers, Stewart, 2001

Name 3 theories that explain why capital structure matters

Answer 23

1) Trade-off theory → emphasizes taxes
2) Pecking order theory → emphasizes difference in information

3) Free cash flow theory → emphasizes agency costs

Question 24

Capital Structure
Myers, Stewart, 2001

How are companies financing themselves nowadays?

Answer 24

Most of the investment is financed from INTERNAL CASH FLOW (depreciation and retained earnings)

External financing is usually less than 20% of real investment, mostly consists of debt

Question 25

Capital Structure
Myers, Stewart, 2001

Describe the situation with stock issuance

Answer 25

Net STOCK ISSUES are frequently NEGATIVE:

• shares are eliminated in acquisitions
• shares are repurchased rather than issued

Only smaller, riskier and more rapidly growing firms rely heavily on stock issuance.

Question 26

Capital Structure
Myers, Stewart, 2001

Describe the situation with debt in companies

Answer 26

Industry debt ratios are low or negative when profitability and business risk are high (like now).

Pharmaceutical and many prominent growth companies typically operate at negative debt ratios (cash and marketable securities > debt) - probably because a lot of R&D is going on and you need cash.

Firms with valuable growth opportunities tend to have low debt ratios

Question 27

Capital Structure
Myers, Stewart, 2001

Describe tradeoff - theory

Answer 27

Increased leverage is good because you get tax shields, bad because of possible default costs.

The firm will borrow up to the point where the marginal value of tax shields on the additional debt is just offset by the increase in the costs of possible distress.

(marginal benefit of tax shields = marginal costs of financial distress)

Question 28

Capital Structure
Myers, Stewart, 2001

What are costs of financial distress?

Answer 28

1) Direct = the costs of bankruptcy or reorganization

2) Indirect = the agency costs that arise when the firm’s creditworthiness is in doubt

Question 29

Capital Structure
Myers, Stewart, 2001

What doesn’t the trade-off theory account for?

Answer 29

The most profitable companies tend to borrow the least (although they have more taxable income to shield)

The trade-off theory cannot account for the correlation between high profitability and low debt ratios.

Question 30

Capital Structure
Myers, Stewart, 2001

Explain Pecking order theory

Answer 30

Firms will firstly finance themselves from internal financing (retained earnings), then debt, then equity.
This is because of information asymmetry between managers and investors.

If firms issue stock, investors believe that managers have some private information about poor future prospects → that means that equity is overvalued → stock price drops after the announcement of an equity issue.
Also, debt suffers from adverse selection much less than equity, thus, will be issued first.

Question 31

Capital Structure
Myers, Stewart, 2001

What do firm’s debt ratios reflect?

Answer 31

Firms’ debt ratios reflect the cumulative need for external financing - if firms issue equity, they are really reallly in need of it.

Question 32

Capital Structure
Myers, Stewart, 2001

What doesn’t Pecking Order theory explain?

Answer 32

Why financing tactics are not developed to avoid the
financing consequences of managers’ superior information, e.g. use “deferred equity” - a debt, repayable in the firm’s shares in the future. It conveys no information because the manager cannot know whether in the future equity will be over- or undervalued.

Question 33

Capital Structure
Myers, Stewart, 2001

Describe Free Cash Flow Theory

Answer 33

FCF says that dangerously high debt levels will increase firm value, despite the threat of financial distress
(especially designed for mature firms which are prone to overinvest)

FCF is not really a theory predicting how managers will choose capital structures, but a theory about the
consequences of high debt ratios. Helps the trade-off theory explain why managers do not fully exploit
the tax advantages of borrowing.

The theory is based on agency costs. To avoid them, one could increase leverage, which would:
• Discipline managers and strengthen their incentives to maximize value to investors (e.g. covenants that restrict taking too large risks)
• Forces them to generate cash (to repay debt)
• Leveraged buyouts (LBOs) - in the first place considered to be attempts to cut back wasteful
investment and discipline the management

Question 34

Capital Structure
Myers, Stewart, 2001

How do managers transfer the risk of default from creditors to debtors? (act in the interests of shareholders, not debtholders)

How do debtholders deal with this?

Answer 34

1) Investment in riskier assets/risk-shifting/overinvestment → increase the “upside” for stockholders, the “downside” is absorbed by the firm’s creditors (think long call)
2) Borrow more/cash out → pay out cash to stockholders

3) Debt overhang/underinvestment → cut back potential investments (even ones that would increase the overall value of the firm), because cash flows to creditors would be relatively bigger than to equity holders. Creditors would benefit more.
4) “Play for time” → managers conceal problems to prevent creditors from acting to force
immediate bankruptcy (link to options’ logic)

Debt investors (creditors) try to avoid this by writing contracts properly → DEBT COVENANTS restrict additional borrowing, limit dividend payouts and other distributions to stockholders, and provide that debt is immediately due and payable if other covenants are seriously violated.

Question 35

​​”Fintech and banking: What do we know?” (Thakor, Anjan, (2020))

What is fintech?

Answer 35

Fintech is technologically enabled financial innovation that could result in new business models, applications, processes, or products with an associated material effect on financial markets and institutions, and the provision of financial services.

Question 36

​​”Fintech and banking: What do we know?” (Thakor, Anjan, (2020))

What are the goals fintech is trying to achieve?

Answer 36

1. Lower search costs of matching transacting parties.
2. Achieve economies of scale in gathering and using large data.
3. Achieve cheaper and more secure information transmission.
4. Reduce verification costs.

Question 37

​​”Fintech and banking: What do we know?” (Thakor, Anjan, (2020))

What are some examples of fintech services?

Answer 37

1. Credit, deposits and capital raising services
   ● P2P (peer to peer) lending:
   Non-intermediated business model in finance, when there is no bank between investors and borrowers and rather, a fintech platform connects the two. The compensation for such companies comes in the form of fees occurring when the loan is originated and also late payment fees.
   ● Shadow Banks:
   They provide commercial bank services but do not finance with deposits.
2. Payments, clearing and settlement services
   ● Cryptocurrencies
3. Investment management services
   ● High-frequency trading platforms, e-trading, copy tradings, Robo advising for diversification benefits
4. Insurance products
   ● Big data, and IoT (internet of things) allow for more precise insurance contracts

Question 38

​​”Fintech and banking: What do we know?” (Thakor, Anjan, (2020))

What are the 4 RQs in this paper?

Answer 38

Q1: How should we modify our theories of financial intermediation so as to accommodate banks, shadow banks, and non-intermediated solutions?

Q2: How will credit, deposits and capital raising be affected by fintech? Will P2P platforms replace bank lending?

Q3: On payments, clearing and settlement, what will be the role of cryptocurrencies vis-à-vis fiat money and private money creation by banks? How will this affect central banks?

Q4: How will Blockchain-technology-assisted smart contracts transform the financial market, including investment management and insurance?

Question 39

​​”Fintech and banking: What do we know?” (Thakor, Anjan, (2020))

What is the answer to RQ1? (How should we modify our theories of financial intermediation so as to accommodate banks, shadow banks, and non-intermediated solutions?)

Answer 39

1. Incentive conflicts in P2P platforms:
   P2P businesses often have little incentives to regulate their platforms. P2P service providers have no skin in the game in the form of equity. Hence, investors have concerns about trust. One way this could be solved is if the platform was collecting part of repayment, instead.
2. Differences between P2P platforms and banks:
   Banks are trusted to make careful loans and a wider array of intermediation services. There is also such a thing as relationship banking. However, P2P platforms have an advantage - lower operating costs

Question 40

​​”Fintech and banking: What do we know?” (Thakor, Anjan, (2020))

What is the answer to RQ2? (How will credit, deposits and capital raising be affected by fintech? Will P2P platforms replace bank lending?)

Answer 40

1. There is a trend of loan migration from banks to P2P

The loans in P2P are risker, but not necessarily cheaper. This could be explained by the fact that P2P and Banks are not always complements. If the person is not allowed to take a loan in the bank, they might go to P2P platform and get the desired loan, though at a substantial cost. Banks retain advantage with deposit insurance and people’s demand for safe assets. Banks also have better funding access and trust. This effect of migration is more pronounced in countries where fewer people use banking services.

2. Competition from P2P

Competition lowers the banks’ fees. Hence, the banks might get attracted to riskier loans to make more profit.
Empirically, banks improve profitability, asset quality and stability when facing competition. Hence, P2P might actually not be the end for bank lending.

Question 41

​​”Fintech and banking: What do we know?” (Thakor, Anjan, (2020))

What is the answer to RQ3? (On payments, clearing and settlement, what will be the role of cryptocurrencies vis-à-vis fiat money and private money creation by banks? How will this affect central banks?)

Answer 41

1. Digital wallets
   They combine various services payments, keys, tickets, IDs. To a certain extent they come in competition with banks. Moreover, their role is even more important in developing countries, where people sometimes have limited access to financing.
2. Currency
   Cryptocurrency already acts as payments and banks do not (yet) incorporate them in their services. Crypto has a competitive edge BUT it has volatility problems. Thus, it might be wiser to perceive cryptos as investment
3. Central banks
   Producing cash is inefficient and significantly more expensive than electronic payments. Hence, CB are already adapting to fintech by introducing digital currencies (DC) like digital euro. DC enhance settlement efficiency for transactions. It is expected that CBs will control commercial banks better. Moreover, the data on money circulation will be more insightful, promising more effective monetary policies. Also, given the CB will have full supervision over the digital currencies, it will be much easier to impose negative interest rate policies - people will not be able to store the digital money under the mattress anyways.

Question 42

​​”Fintech and banking: What do we know?” (Thakor, Anjan, (2020))

What is the answer to RQ4? (How will Blockchain-technology-assisted smart contracts transform the financial market, including investment management and insurance?)

Answer 42

1. Blockchain technology

Further expand the space for feasible contracts. It enables the agents who have no trust in each other to collaborate without having to go through a central authority. Moreover, Blockchain improves efficiency through lowering the contracting costs, intermediary costs, verification costs and other types of costs. Also has applications that increase accuracy and offer more tailored experience. E.g: car insurance can be embedded in the car itself. As the driver drives, the data is generated which can be fed continuously to the insurance contracts, so it adjusts the terms of the contract based on this data.

2. Bank role with the emergence of Blockchain

Banks will adapt and become the providers of the smart contracts. The adaption is likely because banks are more trusted with things such as data the smart contract is gathering. Due to data collection, there will be privacy concerns also.