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Corporate finance Flashcards

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1
Q

What are the main summary bullets from chapter 10 (Best practices in capital budgeting)

A
  • Before making a capital budgeting decision, you need to stress test the assumptions of future cash flows (i.e. identify and evaluate threats)
  • Solutions include sensitivity analysis and break-even analysis
    • More complex analysis will include monte carlo
  • Firms are constantly modifying operations, thus real options are valuable
  • 4 real options:
    1) Expansion,
    2) abandonment,
    3) timing,
    4) production flexibility
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2
Q

What are the main summary bullets from chapter 11 (Investment, strategy, and economic rents)

HIGH RISK

A
  • NPV can appear positive for two reasons:
    1) Firm can expect economic rents
    2) or there are biases or errors in cash flow forecast (false positive NPV)
  • Good managers try to avoid false positive by investing in areas where they have a clear competitive advantage (economic rents/abnormal returns are likely)
  • They also try to ensure they understnad how prices (future CF) will be affected by entry or expansion of competitors
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3
Q

What are the main summary bullets from chapter 12 (Agency problems, compensation and performance measurement)

A
  • Due to separation of ownership and management, agency costs are inevitable.
    Typical agency problems include
    1) Reduced effort and Perks
    2) Reduce or avoid risk
    3) Over investment (Empire building and Entrenching investments)
  • Incentives are needed to align interests of managers with shareholders, to maximize shareholder value –> stock options (variable pay)
  • Problems with options include:
    1) Stocks exposes managers for market risk (undiversifiable risk)
    2) Today’s stock price reflects expected future performance
    3) Incentivize manipulation of stock, or shortermism
    Lower managers’s variable pay are linked to accounting income (net ROI) or EVA (economic value add)
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4
Q

What are the 5 lessons of market efficiency?

A

1) Markets have no memory
2) Trust market prices (information is priced in, difficult to make superior returns)
3) Read the entrails (i.e. understand expectation of the future through market prices and investor behaviour e.g. market’s assessment of a companies debt risk)
4) The do-it-yourself alternative (investors can diversify and leverage their investments themselves)
5) Seen one stock, seen them all (investors buy a stock due its promise of a fair risk return relationship)

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5
Q

What are the 3 forms of market efficiency?

A

In an efficient market the investor is compensated for time value of money and risk exposure to market.

Weak
- Prices reflect all past series of historic prices, cannot make superior returns from historic patterns in stock prices. Prices are random
Semi-strong
- Prices reflect all public available information, i.e. not possible to make superior returns by reading annual reports
Strong
- Prices reflect ALL information, i.e. superior return are extremely hard to find

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6
Q

What is arbitrage and what are the limits to arbitrage?

A
  • Investment strategy that guarantees superior returns without any risk (buy low, sell high).
  • Also called convergence trading, as arbitrage can ensure market efficiency, i.e. converge prices to their fundamentals
  • Limits comes when there are significant trading costs or uncertainties.
  • Short selling can be difficult, as you need to sell a stock that you do not own. (Borrow a stock to sell)
  • Furthermore, “markets can stay inefficient longer than you can stay solvent”
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7
Q

What are the main summary bullets from chapter 13 (Efficient market and behavioural finance)

A
  • Competition between investors tend to produce an efficient market
  • Efficient market hypothesis and its 3 forms
  • Limits to arbitrage may explain why asset prices can get out of line to its fundamentals
  • Deviations from market efficiency do to phychological traits of investors (prospect theory, overconfidence, slow to response to new information)
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8
Q

What is behavioural finance and what are investor characteristics in behavior?

A

Bubbles can occur

  • Attituted towards risk (investors are averse towards losses) - Prospect theory
  • Overconfidence in predicting the future
  • Sluggish in reacting to new information (conservative)
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9
Q

What are the main summary bullets from chapter 16 (Pay-out policy)

A
  • Payout policy is the answer to 2 questions: How much should the cast pay out to its shareholders and should the cash be distributed in the form of DIV or stock repurchases?
  • How much should be paid out? Cash is surplus after answering the 3 following questions:
    1) Is all positive-NPV project invested in?
    2) Is the firm’s debt level prudent and manageable?
    3) Does the firm have a sufficient war chest of cash or unused debt capacity to cover for unexpected opportunities or setbacks?
  • Repurchasing are more flexible than dividend (investors expects dividend to continue)
  • There is a large information content of dividends as it also tells something about the managements positive expectations of future earnings
  • Difference between a growth company and a mature company
  • In a perfect capital market (M&M) there would be no difference in cash dividends and repurchasing on market value of firm (since any change in divident must come from sale or repurchase of shares), but..
  • Rightists: Maximize dividends (financial discipline)
  • Radical left: Differences in tax treatment of capital gains and dividends (choose the one that is lowest)
  • In the end effect on market value; short-run is tactical, long run strategy depends on life cycle of a company
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10
Q

What are the main summary bullets from chapter 17 (Does debt policy matter?)

A
  • A FM takes all the firm’s real assets and sell them to investors as a package of securities
  • M&M proposition 1 (perfect capital markets):
  • A firm’s value is independent of capital structure. (asset side held constant)
  • -> Allows for separation of investment and financing decisions
  • Investors can leverage themselves if they want to (borrow on same terms)
  • M&M II: Higher debt increase risk (financial risk), offset by the increase in expected return to shareholders
  • Thus –> wacc does not depend on capital structure
  • Opposing view: Traditionalists
  • Market imperfections makes it costly to borrow as an investor
  • Thus there is an unsatisfied clientele of investors
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11
Q

What are the main summary bullets from chapter 18 (How much should a corporation borrow?)

A
  • Capital structure theories (trade-off, pecking order, Jensen’s free cash flow)
  • Costs of financial distress (direct/indirect and costs short of bankrupcy)
  • Financial slack
  • Pecking order stresses financial slack to ensure a firm is not caught in the end of the pecking order
  • Slack can also create agency costs or overinvestments, thus increasing debt can increase financial diciplin (Jensen’s cash flow theory)
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12
Q

What are the assumptions of perfect capital markets?

A
  • Rational agents
  • no transaction costs
  • no tax
  • no bankruptcy cost
  • symmetric information
  • No agency cost (no conflicting interests)
  • complete markets with no financial innovation
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13
Q

What are the theories concerning capital structure?

A

No universal theory. Firms are supposed to pick a capital structure that maximize firm value.

  • The trade off theory
  • The Pecking order
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14
Q

What is the trade-off theory?

A

Optimal level of capital structure concerns a trade-off

  • Emphasize the trade-off between interest tax shield and costs of financial distress
  • Value of all-equity firm + PV ITS - PV cost of financial distress
  • The firm should maximize the formula, where the marginal cost of financial distress is offset by the benefit of ITS

Cost of financial distress can be broken into:

  • Bankruptcy costs (direct (i.e fees) and indirect (i.e. difficulty going through liquidation or reorganization)
  • Costs of financial distress short of bankruptcy (i.e. doubts of credit worthiness, conflict of interest between bond holders and stockholders (“games”), and transaction costs to avoid “games”

Does not explain why some firms have lower or higher capital structure than others (e.g. why profitable companies have a low debt ratio) –> turn to pecking order

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15
Q

What it the pecking order theory?

A

Firms use internal financing when available and choose debt over equity when external financing is needed
- Thus, less profitable firms borrow more

  • -> A consequence of asymmetric information
  • Managers know more than investors
  • Managers are reluctant to issue stock if it is undervalued –> Thus issuing stock is bad news (overvalued)
  • Debt is better, and equity is only used if debt capacity is running out

Pecking order value slack, because it serve as an internal financing tool (excess cash). But, remember downside with financial slack.

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16
Q

What are the main summary bullets from chapter 19 (Financing and valuation)

A

2 ways to consider financing in valuation of a project

  • Adj. discount rate or *Adjusted PV
  • wacc only works for projects that are carbon copy of business (business risk and debt ratio)
  • wacc assumes constant rebalancing
  • wacc only takes ITS into account (not other financing effects)
  • FCF does not include value of ITS, but the r* takes that into account by adjusting to after tax borrow rate

Businesses are usually valued in two steps.
1) FCF
2) Horizon value (competitors arrive)
Then subtract debt to get value of equity

Debt capacity refers to the chosen borrow rate considering all of the firms assets

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17
Q

What are the main summary bullets from chapter 20 (Understanding options)

A

Call option: the option to buy an asset at a specific exercise price on (or before) a specified maturity date
Put option: the option to sell an asset at a specific exercise price on (or before) a specified maturity date

An option increases in value if/with

  • Volatility (no down side, only upside)
  • The further “in the money” the option is
  • Low exercise price (if call option, vice versa put)
  • Interest rate (relates to the delay of paying the exercise price)
  • Time to maturity
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18
Q

What are the main summary bullets from chapter 21 (Valuing options)

A

Price the option by finding a replicating portfolio with the same payoff as the option (a package of the underlying asset and risk free loan)

  • Risk neutral probabilities, find expected future “risk free” payoff and discount back to PV
  • Binomial method, dividing the option’s life into subperiods. Replicating portfolio in each stage
  • BS formula, price if the option takes a continuum of possible future values
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19
Q

What are the main summary bullets from chapter 22 (Real options)

HIGH RISK

A

4 important real option

1) The option to make follow on investments (often why you would take on projects that would appear to have negative NPV, as you have call options on follow on projects. Today’s investment can create tomorrows opportunity)
2) The option to wait (and learn) before investing (equivalent to owning a call option on the investment project. Call is exercised when you commit. Valuable in times of high uncertainty and immediate cash flows are small
3) The option to abandon (provides partial insurance for down-side, like buying a put)
4) The option to vary the firm’s output or its production methods (build in flexibility in production)

  • DCF is needed to price the underlying asset upon which the real option is based.
  • When estimating a real option, we estimates its value as if it was traded (same risk characteristics as with traded securities), positive if required return exceed initial investment
  • The after-tax discount rate is used in the risk neutral method
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20
Q

What are the main summary bullets from chapter 25 (Leasing)

A

Lease is an extended rental agreement, a source of financing for assets. Owner (lessor) allows user (lessee) to use the asset in exchange for regular lease payments

Types:

  • “Buy vs. lease”: Operating (short-term, cancelable), lessor bears risk of ownership
  • -> Attractive if Eq. annual cost is higher than annual lease payment
  • “Borrow vs. lease”: Financial lease (long-term, non-cancelable, lessee bears risk of ownership
  • -> like signing a secured loan
  • Leveraged (involves a lender, lessor and lesse)
  • Types of service should also be taken into account of value of lease, i.e. if lessor provides maintenance (full-service agreement) or if it is lessee’s responsibility (net lease)

If lessor and lesse are in same tax bracket one looses at the expense of the other
If lessee pays a lower tax, it is possible for them to both benefit at the expense of the government

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21
Q

Why lease?

A
  • Convenience (lemon problem, rent a car)
  • Cancellation option is valuable
  • Maintenance can be provided
  • Standardization leads to lower TC and administration costs (easier for smaller companies to lease and for lessors makes it less risky)
  • Tax shields can be used (lessor owns asset and deducts its dep from taxable income)
  • Leasing and financial distress (lessors kind of act as secured lenders)
  • Avoiding alternative minimum tax

Dubious reasons

  • Avoid CAPEX controls (avoid procedures needed to buy an asset)
  • Preserve capital (provides financing, but the firm could just as well have borrowed)
  • Off-balance sheet financing (if a lease is seen as an operating lease it should not be capitalized, thus leverage understate the true leverage of the firm)
  • Affect book income (affect income statement by having lease payment less than depreciation and interest expense in a buy-and-borrow scenario)
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22
Q

What are the main summary bullets from chapter 31 (Mergers)

A

A merger can create added value through synergies

Gains can come from

  • Economies of scale
  • Economies of vertical integration
  • Combination of complimentary resources
  • Redeployment of surplus funds
  • Create efficiency with new management
  • Consolidation in industry (decrease excess supply)

Dubious reasons include: diversification, lower borrowing cost, pump up earnings per share

Cost if the premium that a buyer pays above the market value as a separate company.

Acquisition can be in cash and stock issuance, in the latter cost depends on what the shares are worth post merger.

Ensure that the purchase comply with anti-trust; choose procedure (1. merge assets and liabilities of seller, buy the stock of the seller, buy individual assets of the seller), and the tax status of the merger.

Mergers is often a negotiation, but it can happen that the buyer needs to make a tender offer. Offensive and defensive strategies. Gains are usually pushed towards the selling shareholders

Merger activity is highest in bull markets and in industries coping with change (deregulation, demand and tech changes)

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23
Q

What are the main summary bullets from chapter 32 (Corporate restructuring)

HIGH RISK

A

Companies frequently reorganize by adding new businesses or disposing of existing ones

  • Alter capital structure
  • Change ownership and control

Types of restructuring:

  • LBO (a take-over or buyout of a firm)
  • Leveraged restructuring (no change in ownership, but the firm is put on a “diet” and excess cash is paid out)

PE are usually the players and can be seen as temporary conglomerates

Diversification seem to destroy value, which can also be seen by fewer conglomerates

  • Harder to set incentives for managers
  • Internal capital markets are inefficient

Asset divestment (good news for investors as efficiency and profits are expected to increase)

  • Spin-off
  • Carve-out
  • Asset sale
  • Privatization

Reorganization due to financial distress to arrange a work-out.

  • If they prove impossible, a company files for chapter 11 (bankruptcy), with the purpose of getting back on their feet.
  • Chapter 11 tends to favor debtor, in contrary to other countries
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24
Q

What are the main summary bullets from chapter 9 (Risk and the cost of capital)

HIGH RISK

A

CCOC is the rate of return that investores require on the portfolio of all the firm’s outstanding debt and equity.

CAPM is a short-term model, but can use a short cut by using long term interest rate and the difference in market returns and long term treasuries (lower slope and higher interception of SML)

  • The true cost of capital depends on the use of which the capital is put
  • -> Find pure play beta
  • or identify beta characteristics, a high asset beta is seen with: High cyclical firms, operating leverage
  • Don’t be fooled by diversifyable risk and do not use fudge factors (takeaway! Adjust cash flows instead)
  • When using adjusted discount rate, you assume that cumulative risk increases at a constant rate as you look further into the future (constant beta), (but projects may change in risk)
  • CEQ, converts expected cash flows into certain cash flows by giving expected cash flows a high cut, i.e. the return that investors (before) required for taking on risk
  • Thus, CEQ split time value of money and uncertainty up, only including time value of money in future cash flows
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25
Q

What are the four estimates for horizon value?

A
  • Constant growth model of FCF (r and g)
  • P/E ratio of comparables
  • Market to book value comparables
  • Horizon date is when PVGO=0, then EPS_H+1 / r
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26
Q

What are the main summary bullets from chapter 4 (Value of common stock) HIGH RISK

A

PV of stock = stream of CF discounted at the expected rate investors receive on other securities with same risk

  • Fundamental valuation: P0 = DIV1+P1 / 1+r –> But it just becomes dependent on DIVt
  • Constant growth model (perpetuity) –> Used to estimate market capitalization rate (assumption: mature, low risk firms) –> often not possible, thus 2-state model
    General DCF formula transformed: P0 = EPS1/r + PVGO

EPS/r is a no growth scenario
PVGO: NPV projects firm will make to grow (above r return)

Growth stock has a large share of PVGO to EPS/r value

Calculate company value in a 2-step process w/ a Horizon value discounted back to PV. Here it is possible to also find the share price (by dividing value)

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27
Q

What are the main summary bullets from chapter 5 (NPV and other investment criteria) HIGH RISK

A
  • Payback period (only accept project that recover investment within an arbitrary limit - ad hoc rule)
  • -> Ignores cash flows outside of period and takes no account of opp cost
  • IRR, give right result if properly used. Falls short if
  • lending or borrowing? (if borrow, you should accept when IRRr)
  • multiple rates of return (if CF signs change more than ones)
  • Mutually exclusive projects (IRR may give wrong ranking, use incremental cash flows, and see if IRR>r)
  • Cost of capital for near-term cash flows may be different from the cost of distant cash flows (if the term structure is not flat)

If capital is rationed, the calculate profitability index (NPV/investment) –> but falls short if capital is limited in more than one period or if other constraints prevail

  • Soft rationing, provides a proxy for budget limit (self-imposed limits)
  • Hard rationing reflect market imperfection, if the company does not have access to well-functioning capital markets to raise money to invest in positive NPV projects
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28
Q

What is one of the main assumptions of NPV?

A

Access to well-functioning capital markets

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29
Q

What are the main summary bullets from chapter 6 (Making investment decisions with NPV rule)

HIGH RISK

A

Checklist to avoid forecasting cash flows wrongfully:

  • Discount CF, not profits
    FCF: Profit after tax + dep - investment in NWC and CAPEX
  • Estimate incremental cash flows
    –> Include opportunity cost of asset use, forget sunk cost, include indirect effect of the project, e.g. impact to other sales
  • Treat inflation consistently
  • Forecast CF as if they were all equity financed (in order to separate investment from financing decisions)

When choosing between two machines, convert series of cash flows into annual streams of CF –> to get eq. annual cost (in real terms)

30
Q

What are the main summary bullets from chapter 7 (Intro to risk and return)

A
  • Risk should be seen in a portfolio context, which only leaves market risk and diversify specific risk
  • Spread of outcomes are measured by standard deviation
  • A securities contribution of risk of a well-diversified portfolio is measured by its beta (sensitivity to market movements per 1%)
  • The SD of a diversified portfolio is proportional to its average beta
  • Corporate diversification is redundant as the investor can do it better by themselves (here the value additivity is a main assumption, which holds)
31
Q

What are the main summary bullets from chapter 8 (Portfolio Theory and the CAPM)

A

Investors want to maximize the risk/return trade-off

  • -> Find the efficient portfolio (highest sharp ratio)
  • Investors should choose this portfolio regardless of risk preference as they can mix it with the risk free rate

Investors are concerned with the risk they cannot diversify and requires a premium to take on that risk –> CAPM
- Fundamental idea with CAPM –> each security expected risk premium should increase in proportion to its beta

  • The arbitrary pricing theory offers an alternative with more variables (macro) being exposed to that influence the level of risk premium (with b representing sensitivity to each factor –> but, the theory does not suggest which factors
32
Q

What are Fama and French’s 3 factor model?

A

Expected return on a stock depends on the following 3 factors:

1) Return on market less risk free rate
2) Difference between return on small and large cap stocks
3) Difference between the return on stocks with high book-to-market ratios and stocks with low

33
Q

Why is IRR unreliable in ranking projects (if you don’t look at incremental cash flows)?

A

Projects have different:

  • scale of initial investment
  • patterns of cash flows over time (timing of cash flow, i.e. economic life)

Both projects need to have same opp. cost of capital!

34
Q

What is “An estimate of future equity risk premium central for”?

A

Equity risk premium measures excess return from investing in equities rather than risk free asset.

  • Asset allocation decisions.
  • Calculating cost of equity capital.
  • Valuing companies and stocks.
  • Evaluating capital budgeting proposals.
  • Determining fair rates of return for regulated businesses.

But can only be measured historically

35
Q

Explain why it is important that managers have a clear understanding of their firm’s competitive advantage

A

 Then managers are able identify the source of economic rents.
 A positive NPV for a new project is only credible if it is likely that the company has a competitive advantage.
 Then managers are better able to separate truly positive NPV projects from negative NPV projects showing positive NPV due to estimation errors in cash flow forecasts.

36
Q

Difference between investment and financing decisions:

A

oInstitutional knowledge.
oReversibility.
oDifferences between product market and capital market and implications for existence of projects with positive NPV.

37
Q

How do firms pay dividends?

A

A regular cash dividend (e.g. each quarter or year).
 An extra or special dividend.
A stock dividend (i.e. not in the form of cash).

38
Q

How Firms Repurchase Stock?

A

A buyback reduces the number of shares in a company held by the public. … In the near term, the stock price may rise because shareholders know that a buyback will immediately boost earnings per share

 Open market transaction
 Tender offer (investor proposes buying shares from every shareholder of a publicly traded company for a certain price at a certain time)
 Dutch auction (The purchase price is the lowest price that allows the firm to buy the number of share)
 Direct negotiation with major shareholder

39
Q

Does payout policy matter in perfect capital markets? (M&M proof)

A

o In perfect capital markets the choice between dividends and share repurchases has no effect on the market value of the firm.
o In perfect capital markets increased dividend payments financed by issuing stocks has no effect on the market value of the firm (holding the firm’s assets, investments, and borrowing policy fixed).

40
Q

How does the effect of issue or repurchase stock affect dividend?

A

o Increase dividends -> Issue stock.

o Decrease dividends -> Repurchase stock.

41
Q

Rightist view of pay-out policy considering excess cash (imperfection)

A

 In mature companies with plenty of free cash flow but few profitable investment opportunities shareholders do not always trust managers to spend retained earnings wisely and they fear overinvestment
(e.g. empire building).
 Payout policy is mixed up with firm’s investment and operating decisions.
 Increase in payout (dividend or share repurchase) may lead to a rise in stock price not because dividends are valuable in themselves, but because they signal a more careful, value-oriented investment policy.

42
Q

Name the assumptions regarding the manager’s objective for the three theories of financing of corporations

A

Aligned interest -> Thus financing decision is in the interest of the shareholders
- Trade-off and pecking order

Self-interest -> Shareholders want debt to reduce agency cost
- Jensen’s free cash flow

43
Q

Introducing corporate taxes in an otherwise perfect capital market?

A

o Company debt and personal debt are no longer perfect substitutes: Corporate capital structure is no longer irrelevant.
o Company is now able to offer investors something they cannot replicate by homemade leverage.
o Investors can borrow through company at after corporate tax interest rate, while they borrow personally at pre corporate tax interest rate.

44
Q

When do you prefer corporate borrowing?

A

if (1 – TD) > (1 – TE) * (1 – TC).

45
Q

What is bakruptcy cost?

A

o Costs of using the legal mechanism allowing creditors to take over when a firm defaults (i.e. legal and administrative costs: fees to lawyers, accountants, and consultants) are direct bankruptcy costs.
o Indirect bankruptcy costs reflect the difficulties of managing a company, while it is going through bankruptcy.
o Assumption: Sum of direct and indirect costs of bankruptcy amount to a significant number and depend on the size of the company and the complexity and the time involved in the bankruptcy proceedings.

46
Q

What is risk shifting (asset substitution) and under investment problem?

A

In cases of Financial Distress without Bankruptcy

 FM acting strictly in shareholders’ interests (and against creditor’s interest) favors risky projects over safe ones.
 FM is willing to accept risky projects with negative NPV.

FM is willing to reject projects with positive NPV if financed by issuing equity to current shareholders.

47
Q

What is Costs of Financial Distress without Bankruptcy?

A

oCustomers, suppliers, and employees are reluctant to do business with a firm in financial distress that might not be around for long.
oHighly leveraged firms seem less likely to survive in industries being deregulated causing restructurings, increased competition, new investments and improvements in operating efficiency.

48
Q

What is the agency cost of borrowing?

A

o Conflicts of interest between FM / stockholders and bondholders of firms in financial distress can result in poor operating and investment decisions. This is an agency cost of borrowing.
o Ex post: Bondholders pay the cost of playing games.
o Ex ante: Stockholders pay the cost of playing games

o It costs money to save money: It is costly to negotiate and write the fine print in debt contracts, and it is costly for bondholders to monitor and enforce the debt contract..

49
Q

What does internal funds consist of?

A

retained earnings,
cash,
sale of marketable assets

50
Q

When does the wacc formula work?

A

 The formula gives the right discount rate only for a company or carbon copy project:
o Project’s business risk is the same as company’s other assets.
o Project supports same fraction of debt-to-value as in the company’s overall capital structure.

51
Q

What types of financing costs is there?

A

PV (Issue Costs),
PV (Interest Tax
Shields), and
PV (Subsidized Financing).

52
Q

When to use APV?

A

The APV method to value a project should be used when the project’s level of debt is known over the life of the project.

If you use APV approach you are not only able to see APV but also where that value is coming from!

53
Q

What assumptions do you make when unlevering comparable?

A 
- Only financing side effect is interest tax shields on debt supported by project.
 Only corporate taxes are considered.
 Debt is risk free.
 Debt ratio is constant.
 Debt rebalancing is continuous.

1) Unlever to find business risk
2) relever for new project to add financial risk

54
Q

What is the opp cost of capital?

A

o Expected rate of return offered in capital markets by equivalent- risk assets.
o Depends on risk of project’s cash flows.
o Correct discount rate for project if it is all-equity financed.

r* reflects financing side-effects (only ITS though)

55
Q

When are potential gains to lessor and lessee highest?

A

 Lessor’s tax rate&raquo_space; lessee’s tax rate.
 The depreciation tax shields are received early in the lease period.
 The lease period is long. Lease payments are concentrated at end of the lease period.
 The interest rate is high (if rD = 0  no advantage in PV terms to postpone tax).

56
Q

Winners and losers in mergers?

A

o Investment bankers, lawyers and accountants always win.
o Unsuccessful bidders often win by selling off their holdings in target companies at substantial profits.
o Selling shareholders on average get a positive abnormal return.
o Overall value of merged firm increases (slightly) on average.
o Buying shareholders on average seem to loose.

Economists find it hard to agree on whether mergers and acquisitions are beneficial on balance.

57
Q

Why are two firms worth more together than apart?

A

You add value only if you can generate additional economic rents (i.e. have a competitive advantage).

58
Q

What are the potential gains of spin-offs and carve-outs?

A

o Widen investor’s choice.
o Improve incentives for managers.
o Reduce risk of misallocation due to internal capital markets.

59
Q

What are the adv. of PE?

A

o Concentrated ownership.
o Limited life.
o No internal capital markets.
o High powered incentives for managers.

60
Q

LBO’s and MBO’s have been very popular in the US and they have in many cases generated substantial gains to (selling) stockholders. Where did the gains come from?

A

 Free Cash Flow. Debt may be used to force management to reduce free cash flow instead of wasting it in negative NPV projects.
 The junk bond markets. Investors in junk bonds have initially underestimated the risks of default in junk bonds (junk bond financed takeovers may have been driven by artificially cheap funding).
 Leverage and taxes. However, the value of interest tax shields was just not big enough to explain the observed gains in market value.
 Other stakeholders. However, the value losses suffered by bondholders are not large enough to explain stockholders’ gains.
 Leverage and incentives. Management works harder (and smarter) after a LBO. It has better incentives, because it has to generate cash for debt service, and it becomes owners rather than just employees. Management has strong incentives to reduce capital expenditures, sell non-core assets, and increase profitability of core business (operating profits) by cutting back operating expenses and reduce bureaucracy.

61
Q

What are the purpose of leveraged restructurings?

A

force mature, cash cow firms to

  • pour out cash to investors,
  • reduce operating costs and capital expenditures,
  • and use assets more efficiently.
62
Q

What are motives for privatization?

A

 Increased efficiency. Company is exposed to discipline of competition and insulated from political influence on investment and operating decisions.
 Share ownership. Privatizations encourage share ownership. Managers and employees can be given stronger incentives to cut costs and add economic value.
 Revenue for government.

63
Q

Describe PE

A
  • Consists of general partners and limited partners
  • looking to acquire companies with high cash flows that are in the need of a restructuring

Temporary conglomerate –> buys up mature businesses (either in specialized or in unrelated industries) with plenty of free cash flow in order to

  • > restructure,
  • > sell noncore assets,
  • > improve operations and management.

exits either by an IPO or by selling to another firm or fund.

Alternative investment class

64
Q

What is an option?

A

An option is a right but not an obligation to
take action - option valuation puts value on
the opportunity to react

Rights that are not obligations are always
worth at least zero – you would never be
better off with less flexibility / opportunities to
react!

Option value depends on the future value of
the underlying asset

65
Q

Real options take away

A

Options highlight the value of decision
making

Option theory helps to improve decision
making and project selection

66
Q

How can firms protect themselves from a hostile takeover?

A 
Greenmail (give the acquirer some money to make them disappear) 
Poison pill (make the target’s shares more unfavorable for the acquiring firm, e.g. higher costs of acquisitions - Creating disincentives for the acquiring firm)

Pre-offer

  • Poison pill: Existing shareholders can buy additional stock at a bargain if a bidder buys a significant share of the firm
  • Poison put - Bondholders sells debt back to the firm if changes in ownership structure
  • Pacman defense - Buy the attempting acquiring firm - Attack is the best defense!
  • Shark repellent - Regulations for voting restrictions, majority decisions etc.
  • Golden parachutes - Raise bonuses to executives if employment is terminated
  • White Knight - Alliance with another firm
  • Selling the crown jewels

Post-offer:

  • Litigation
  • Asset restructuring
  • Liability restrucuturing

Why defense?

1) to push up the price,
2) belief in superior performance of the current management, and
3) management’s own interests

67
Q

Asymmetric information in merger buy decision

A

If buying firm managers were optimistic, they would strongly prefer to finance the merger with cash.

Financing with stock would be favored by pessimistic managers who think their company’s shares are overvalued.

68
Q

What is a corporate restructuring?

A

Restructuring is a type of corporate action taken when significantly modifying the debt, operations or structure of a company as a means of potentially eliminating financial harm and improving the business.

69
Q

How does restructuring relate to a bankruptcy?

A
  • the firm accepts a restructuring plan with the creditors. If this is not accepted, the firm must declare itself bankrupt.
  • When a company is having trouble making payments on its debt, it will often consolidate and adjust the terms of the debt in a debt restructuring, creating a way to pay off bond holders.
70
Q

Difference between chapter 7 and 11

A

7 oversee the firm’s death and dismemberment (often launched by creditors)

11 try to get the company back alive (often launched by the firm itself, cannot finance their debt for example) –> design a new capital structure

A workout is when a firm seek out their creditors themselves to work out a solution

Corporate Finance (1 decks)

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