Corporate Finance Flashcards
What Determines PVGO?
Formula for estimating TV and CFs with Terminal Growth Method
The price of a stock can be decomposed into two components
Assume that the firm follows a policy of reinvesting a fraction k of its yearly earnings in new projects. k is called…
the plowback ratio and (= reinvestment rate or retention rate) and 1 - k is the payout ratio
Equation sources and uses of funds
Dividend Policy - Stylized facts documented by Lintner (1956):
- Firms have long-run target dividend payout ratios
- Dividend policies are sticky. Cuts are extremely rare, and managers will only raise the dividend if long-run sustainable earnings have risen
- Managers focus more on dividend changes than on absolute levels
Does dividend policy matter? In theory?
Famous 1961 article by Miller and Modigliani (MM), showing that in a perfect capital market (no taxes, transactions costs, or inefficiencies), dividend policy is irrelevant.
Firm has 1,000 shares outstanding, and assets worth £ 12,000 so that the share price is £ 12 - if dividend of £ 1,000 is paid out, what are the new shares worth?
The above argument shows the fallacy of arguments often made in favor of dividend payments:
-) Dividend irrelevance is inconsistent with the stock price being the PV of future dividends.
-) The ‘bird-in-the-hand’ fallacy : since dividends are cash in hand, while capital gains are risky, increasing dividends should make the equity less risky, and hence more valuable.
- Paying a dividend of $1,000 entails a capital loss of $1,000 for certain. Thus, it trades a certain income (dividend) with a certain loss (capital loss), rather than trading something certain for something risky
- Both of these notions are fully consistent. Dividends are irrelevant because a higher dividend today requires you to sell more stock to finance the dividend. Therefore, future dividends are lower because they are shared among a greater number of shareholders. It is exactly because the stock price is the PV of all future dividends that makes dividends irrelevant - even though the immediate dividend rises, future dividends fall and these effects cancel out.
Dividends as Signals:
- A higher dividend may raise a firm’s value by signaling management’s favorable information about the firm’s future earnings
- Evidence supports this signaling hypothesis: Aharony and Swary (1980) found that dividend decreases (increases) are associated with the stock price falling 3.76% (rising 0.72%)
- More recently, Ham, Kaplan, and Leary (2020) found that dividend decreases (increases) are associated with the stock price falling 3.3% (rising 0.9%)
MM does not apply in the presence of market imperfections, which e.g. are:
- Issuance costs
- Taxes
- Agency costs
Pfizer’s stock price is expected to be $112.50 next year. It is paying no dividend, and its stock price is currently $100. The current tax rate on dividends is 50%, and that on capital gains is 20%. Suppose that Pfizer announces that it will pay a $10 dividend next year. What will happen to the stock price upon announcement?
- Step 1: Calculate the after-tax rate of return under the current no-dividend policy: Capital gain is $112.50 - $100 = $12.50 –> tax rate of 20%, the tax is $2.50. The after-tax income is $12.50 - $2.50 = $10 = 10%
- Step 2: Under the new policy, the after-tax rate of return must remain at 10%. Pfizer’s business and financial risk are unchanged by the dividend policy, so the rate of return must also be unchanged
- Step 3: Solve for the new stock price that gives an after-tax rate of return of 10%. New capital gains is $2.5, after tax $2.0; dividend $10 * 0.5 (tax rate); Total after-tax
income is given by Post-Tax Dividend + Post-Tax Capital Gain
= 10 (1 - 0.5) + (102.50 - P)(1 - 0.2) = 87 - 0.8P –> of
(87 - 0.8P) / P = 10% which yields P = $96.67
If taxes matter, then high-dividend stocks should offer higher pre-tax returns. What does research find?
Mixed/weak evidence
Dividend Policy - The Effect of Agency Costs
- Agency costs are the loss in frm value that results from managers having different interests from shareholders
- Dividends force the payout of excess cash, preventing managers from wasting it. This is particularly the case since dividends are sticky and hard to cut later without a strong negative market reaction
- If we agency costs matter, we would expect dividends to be higher if: (-) High agency costs, measured by a high number of shareholders (Shhr) and a low percentage of the firm held by insiders (Ins). (-) Low cash needs (since dividends are a use of cash), measured by a low growth rate in revenues (Grow) and low volatility (Beta).
Costs / benefits of dividends:
Modigliani and Miller’s (1958) Proposition I states that in a perfect capital market, a firm’s value…?
…is independent of capital structure
How Leverage A§ects Expected Returns - rE and rA
What are Miller and Modigliani’s (MM) two propositions?
WACC and rA are conceptually different, but in a perfect capital market…
…they are numerically the same. A company cannot reduce its WACC below the level that it would have if it were all Equity-financed: In a perfect capital market, WACC is always rA
Formula for asset beta
Where might violations of MMís propositions arise from?
- Taxes
- Bankruptcy costs
- Agency costs
- Asymmetric information
Value of the tax shield for a firm (APV)
The tax advantage of debt in the presence of both corporate and personal taxes becomes
Reasons why the value of a firm decreases in a bankruptcy
- lawyer’s fees
- fire sales
- intangible assets (e.g. half-finished R&D project cancelled because of people leaving, etc.)
- Even before bankruptcy, employees, customers, and suppliers may leave a firm
WACC with Corporate and Personal Taxes
With taxes and bankruptcy costs, the WACC curve now becomes:
Why does biotechnology has so little debt?
Low profits, thus a much lower tax shield & very high bankruptcy costs (tax shield)
Opposite:
Air transport - very highly levered, because much lower bankruptcy costs
With taxes and bankruptcy cost, firm value consists of Vu + …
Agency Costs of Equity - why it can be good to take on debt
- management is forced to be more capita-disciplined
- It forces the manager to pay out free cash rather than wasting it
- changes in equity value have a much higher effect, thus “concentrating” effect of a CEO’s actions
Agency costs - risk-shifting /
Even if debt has a tax shield, and reduces agency costs –> covenants will go up, potentially preventing investments in profitable
When are agency costs very high
If you have a lot of risky investments/investment opportunities
The joint effect of taxes, bankruptcy costs and agency costs leads to a trade-off theory of capital structure. The firm’s target debt-equity ratio depends on a trade-off between:
WACC curve with agency costs and bankruptcy costs
The APV of a project is…
MM-theorem: Examples of real-world “market imperfections”
- Transaction costs
- Taxes
- Market inefficiencies (e.g. government subsidy)
We have calculated Cytec’s WACC at 16.0% - now unlever it to get to rA
The MM formula assumes that the project supports a permanent additional debt ∆D issued at rD - i.e., what is r* if you have found rA and assume fixed or amortized debt
We now relever Inditherm’s rA of 19.5% to take into account the 30% debt financing:
r* = rA(1 - tcL) = 0.195(1 - 0.34 * 0.3) = 17.5%
Key Takeaways: Interaction of Investment and Financing
Decisions
The baseline rule for choosing between alternative investments is simple: pick the one with the highest NPV. However, this does not apply when comparing investments with different lives. In this case we can use one of two equivalent criteria:
compute the equivalent annual cost: the cash flow C of an annuity having the same life and PV as the machine - for Machine B
If resource constraints, calculate Profitability Index:
Using the CAPM to Evaluate Risky Projects - Correct discount rate for a project and correct measure of project risk is its…
What Determines the Equity Beta? What is the formula for Equity Beta?
three forms of market efficiency:
Market efficiency is a theory of…
sharks, not of the average investor
Public debt offerings are subdivided into two types:
- A general offer is made directly to the public at large
- A rights issue is made to existing shareholders only, although these shareholders can sell their right to subscribe to the offering to non-shareholders
Reasons to do mergers
- Economies of scale
- Economies of scope (cross-selling)
- Market power
Three Types of Mergers
- Mergers that create value: grow the pie
- Mergers that redistribute value: split the pie differently
- Mergers that destroy value: shrink the pie
M&A Operational synergies - Contracts:
M&A should only be used if superior to contracts: incomplete
contracts can lead to hold-up problem if high relationship specificity (i.e. the supplier can only supply this company, and you can’t cover “all” possible problems/changes in the contract, apart from e.g. FX, wages, etc.)
Revenue synergies through
- Economies of scope: cross-selling, R&D spillovers
- Combining complementary assets (Pixar’s animated films and Disney’s marketing, advertising and merchandising)
Cost synergies through:
- Economies of scale in R&D, purchasing, production etc.
- Consolidation of excess capacity in declining industry (U.S. commercial banking in 1980s, defence industry in early 1990s)
- Example: Exxon-Mobil led to 14,000 jobs cut and $3.8b of annual pretax savings
- Financial synergies: create internal capital markets
- Disciplinary: get rid of underperforming target management
Mergers That Redistribute Value
- Tax inversion or unused tax shields: redistribute from government
- Market power: redistribute from customers and suppliers
- Market inefficiency: redistribute from target shareholders - Target is undervalued by the market and/or acquirer is overvalued
Mergers That Destroy Value
- Agency problems - Size: not for economies of scale but prestige, higher salary
- Private benefits: buy attractive sector or people (e.g. Block-Tidal)
- Behavioral: overconfident about synergies and ability to manage target
- Surplus funds: Firm has declining investment opportunities, so it uses spare cash to buy a target - But it should return spare cash to shareholders
- Diversification: conglomerates avoid idiosyncratic risk - But investors can diversify themselves; conglomerates suffer a diversification discount
- EPS accretion: merger will increase EPS - A merger is accretive if the post-merger earnings per share (EPS) of the acquiring firm goes up, and dilutive if EPS goes down
While borrowing at a lower promised rate is not necessarily a good
rationale for a merger, related (financing/financial) reasons may be valid:
- The diversified merged company has lower bankruptcy risk, thus reducing expected bankruptcy costs
- The firm can take on more debt and enjoy a larger tax shield
- A large debt issue is more liquid than two smaller debt issues and investors are willing to pay a premium for this
- Caveat: Financial synergies typically used to justify conglomerate mergers where operational synergies are weak
Resistance methods (pre-offer of M&A):
- Staggered board: only part of the board is elected each year. Therefore
control cannot be gained immediately - Supermajority: high percentage of shares needed to approve a merger, usually 80%
- Poison pills: shareholders have rights to buy bonds or preferred stock - Upon a merger these are convertible into stock of the acquiring firm or must be repurchased by the acquiring firm
Resistance methods (post-offer of M&A):
- Litigation: file suit against bidder for violating antitrust or securities laws
- Public relations: argue that acquirer is undervaluing target or will harm stakeholders (e.g. Unilever’s defence against Kraft)
- White knight: invite a ìfriendly investorî to compete with an initial bid
- Asset restructuring: buy assets that the bidder does not want or sell assets that bidder wants (crown jewels)
- Implementing the changes the bidder was intending to undertake (e.g.
Unileverís strategic review)
