Corporate Finance

Question 1

What is Pecking Order Theory?

Answer 1

Managers prefer to finance investments first with retained earnings, then debt and then equity only as a last resort

Question 2

What is Trade Off Theory?

Answer 2

It is the firm’s choice between financing investments with debt or with equity, managers trade-off the benefits of the tax shield of debt and agency benefits, with financial distress costs and agency costs.

There is an optimal ratio firms should be at when their cost of adjusting capital structure is zero.

Question 3

What is a Vertical Merger?

Answer 3

The buying firm buys a company that it directly buys or sells from.

Question 4

What are Poison Pills?

Answer 4

Allowing existing shareholders to purchase shares at a heavily discounted price.

This dilute the value of the shares already owned by the potential buyer firm, making the takeover too expensive.

Question 5

What is a Conglomerate Merger?

Answer 5

Merge with a company in another industry to spread the risk i.e Diversification

Question 6

What is a Carve Out?

Answer 6

part of the original company is detached and made into its own company. the shares in the new company are not given to the shareholders of the parent company but are sold in a public offering.

Unlike spin-offs, parent company generally receives a cash inflow from the process.

Question 7

What is a Horizontal Merger?

Answer 7

Target and Buyer companies are in the same industry.

Question 8

What is a Spin Off?

Answer 8

Detaching part of the original company to make a new company. You give the shares in the new company to the shareholders of the original company.

A spin off can help focus managers as they are only dealing now with a specific line of the original company. This also gives investors more choice.

Question 9

What is a White Knight?

Answer 9

A friendly company is allowed to buy the target firm to prevent a hostile takeover.

Question 10

What is a Staggered Board

Answer 10

Directors serve three year terms on a board of a company but their changeover dates are staggered so that the board all will not change at once.

This reduces the ease at which a potential buyer firm could get their directors onto the board of the target company.

Length of time can deter a bidder

Question 11

What is a Leveraged Buy-Out

Answer 11

1) What - Business of an existing company is bought-out and becomes a separate company
2) How - Parent receives cash, perhaps with some debt or equity of bought-out company
3) Financing - Cash comes from new debt, plus equity invested by PE investor and managers
4) Financed mainly with debt so has high gearing (typically 90%)
5) Structure - Bought-out firm is usually private
6) Concentrated ownership of equity: private investor & managers
7) Why - Motivated by management (better incentives etc) or financing (debt market, tax etc) – not synergy

Question 12

What is Private Equity?

Answer 12

Capital that is not listed on the public exchange. Private equity firms look for firms with potential, privatise them, improve them and then relist them with a public offering.

Improve firms through information and power, or their business links.

Question 13

What is Synergy?

Answer 13

The potential value generated by a merger or an acquisition

Question 14

What is Gearing?

Answer 14

A percentage that expresses the ratio of the level of a company’s debt in relation to its level of equity.

Question 15

What is a Freeze-Out Merger?

Answer 15

helps solve the free rider problem.

If shareholders of the target firm do not sell their shares in the hope that their shares will increase in value post merger, then they could be frozen out from the value of the synergy.

This happens as laws on tender offers allow acquirers to force non-tendering shareholders to sell their shares for the tender offer price.

Question 16

How does an LBO stop the free rider problem?

Answer 16

When a company is bought using Debt, the debt is passed on to the shareholders of the target firm as well.
This stops the free rider problem as the shareholders from the target firm will not benefit from the value of the synergy as the whole company is now financed by debt and therefore there will be no synergy.

Question 17

What is a Toehold?

Answer 17

A Toehold is when a company buys a small amount of a target company’s shares and can do this without having to declare it publicly or directly to the target firm.
it reduces the free rider problem in two ways
1) the firm can accumulate some shares in a toehold and this can slightly reduce the shares needed from the target shareholders after the formal announcement.
2) very often the firm can buy shares at a relatively low price in toehold purchases. this saved money could then be used to make a good enough offer after the announcement so that share holders want to tender. reducing the free rider problem.

Whole argument is quite loose

Question 18

What is Hedonic Editing?

Answer 18

People would rather experience losses together and gains separately. It is part of Prospect Theory.

Results in younger, employed investors finding dividends attractive as it makes it easier to tolerate risk. i.e. guaranteed dividend with uncertain capital gain.

Question 19

What is Mental Accounting?

Answer 19

Maintaining separate mental accounts for different forms of out payment.

Explains older, retired investors finding dividends attractive as they view them as a replacement for wages.

Question 20

What is Loss Aversion?

Answer 20

Losses are perceived more strongly than gains of the same amount are.

Question 21

What is the Winners Curse?

Answer 21

The winning bid will technically always have over paid.

Firm’s experience the winner’s curse in M&A because of hubris (excessive self confidence).

Question 22

What are Heuristics?

Answer 22

Mental shortcut that allow people to solve problems and make decisions quickly

Examples are, Rules of thumb, Guesstimates, Profiling, Common Sense.

Managers use profiling to set dividend policy to satisfy certain investors.

Question 23

What is the Agency Problem?

Answer 23

Shareholder interests can be compromised if managers maximise their self-interest at the expense of organisational profitability. When managers interests do not align with the shareholders.

Question 24

What is Pay to Performance sensitivity?

Answer 24

a. Tests for every dollar generated for the shareholders, how much extra pay should the CEO receive.

Question 25

What is the Audit Committee?

Answer 25

use their financial expertise to inspect the financial report of the company.

Question 26

What is the Nomination Committee?

Answer 26

they decide which fills the vacancies on the board to avoid the CEO’s having too much influence as to who gets hired.

Question 27

What is the Compensation Committee?

Answer 27

in charge of allocating salaries and stopping CEO’s from abusing their power to increase pay.

Question 28

What is the Sarbanes-Oxley act?

Answer 28

The Sarbanes-Oxley Act of 2002 (SOX) is an act passed by U.S. Congress in 2002 to protect investors from the possibility of fraudulent accounting activities by corporations.

Question 29

What is the Modigliani and Miller theory?

Answer 29

In perfect capital markets, holding fixed investment policy of a firm, the firm’s choice of dividend/payout policy is irrelevant and does not affect the initial share price

According to Modigliani-Miller Dividend Irrelevance, they believe that investment and operating decisions steer share prices)

Question 30

What is the Clientele Effect?

Answer 30

Dividend Policy of a firm reflects the tax preferences of its investors. This helps satisfy shareholders.

Question 31

The Agency benefits of paying dividends?

Answer 31

Commitment to dividend payments helps force managers to maximise shareholder value. Dividend payments reduces FCF into the company. This reduces the probability of managers using FCF for their own pleasure.

Question 32

What is the Relative Advantage Formula?

Answer 32

This calculation compares the tax advantage between debt and equity, considering both the capital structure and personal taxes.

1. RAF > 1 : Debt advantage
2. RAF < 1 : Equity advantage
3. RAF = 1 Irrelevant

Question 33

What is the Interest Tax Shield?

Answer 33

It is the amount of tax you save from paying by using debt rather than equity, as debt is corporate tax deductible. It is calculated by multiplying the Corporate Tax Rate by the size of the debt.

Question 34

What is Asymmetric Information?

Answer 34

A situation in which two parties have different levels of information.

Question 35

What is a Stock-Swap Transaction?

Answer 35

Bidder pays for the target firm by issuing new stock and giving it to the target shareholders.

Question 36

What is an Exchange Ratio?

Answer 36

No. of bidders shares received in exchange for each target share.

Question 37

What is Recapitalisation?

Answer 37

it is a Takeover defence where the target firm makes itself less attractive to the buying firm by for example increasing its amount of debt. This would decrease your potential to borrow.

Question 38

What is the Free-Rider Problem?

Answer 38

A person who exerts no effort or money but benefits from transaction.

Question 39

What is a tax shield?

Answer 39

A tax shield is a reduction in taxable income for an individual or corporation achieved through debt. i.e. debt is tax deductible.

Question 40

Agency benefits of debt

Answer 40

Concentration of ownership - less equity
Reduction of wasteful investment - less FCF
Threat of distress commits managers to pursue strategies with greater vigour

Question 41

Agency costs of debt

Answer 41

Excessive risk-taking, as equity holders are gambling debtholders money

Debt overhang - equity don’t invest in +NPV projects as value will go to debtholders and not them.
A solution to this could be Bankruptcy or government bailout

Question 42

Golden Parachute

Answer 42

Extremely lucrative severance package that is guaranteed to a firm’s managers in the event firm is taken over and managers are let go.

Large severance pay acts as a deterrent to potential acquiring firms as there are huge costs involved with replacing management.

Question 43

Genuine motives M A

Answer 43

Large synergies (i.e. cost savings or revenue growth)

Coming from economies of scale, vertical integration, expertise, monopoly gains, efficiency gains.

Question 44

Dubious motives M and A

Answer 44

Diversification
Earnings growth (EPS)
Managerial Motives - (Conflicts of interest)

Question 45

Private Equity firm structure

Answer 45

Limited Liability Partnerships

Limited investors provide most of the cash (e.g. institutional investors or HNWI)
General partner (GP) is fund manager, who earns flat fee plus 20% of the capital gain (carried interest)

Exit via IPO or trade sale

Question 46

Excessively optimistic, overconfident managers

Answer 46

In cash poor firms, they’re prone to reject +NPV projects, as they are reluctant to issue equity due to perceived undervaluation. Also don’t issue debt as they feel they’re not getting the right value for the debt.

In cash rich firms, prone to adopting -NPV projects. They overestimate the NPV, still perceive their equity to be undervalued but they have no need for external financing.

Question 47

Motives for Mergers and Acquisitions

Answer 47

1) Large Synergies

2) Lower costs of capital e.g economies of scale. Problem: new difficulties emerge from running a larger firm.

Question 48

Dubious Motives for Mergers and Acquisitions

Answer 48

1) Reduces risk through diversification. Problem: investors could just achieve this themselves.
2) Lower costs of capital e.g economies of scale. Problem: new difficulties emerge from running a larger firm.
3) Lower interest rates. Problem: this offers a return to bondholders and not shareholders.
4) Overconfidence. Problem: More of a judgement error than a motivation.
5) Managerial Motives, e.g aspirations of running a larger firm.

Question 49

Effects of Mergers and Acquisitions

Answer 49

Antonio et al. (2008)
1) Takeovers seem to add value, on average
Moeller et al. (2005) find average abnormal returns of +1.1% from 1980-2001.

2) Bidder is likely to pay a premium for the target. i.e the winners curse. Antonio et al. (2008) found an average premium in the UK of 45% from 1985-2004.
3) All of the gains on average go to the target companies shareholders. (Antonio et al. (2008)

Question 50

Effects of Overconfidence

Answer 50

1) likely they will over pay due to the winners curse
2) if both buyer and seller are overconfident then the premium could be extremely large
3) Market will react negatively to over confident transactions
4) Over confident managers would prefer to pay with cash as they believe their own equity to be under valued.

Question 51

What trade off theory cannot explain

Answer 51

1) Most successful companies borrow the least
2) Companies rarely make major shifts in capital structure just because of taxes
3) Debt ratios today are no higher than they were in the 1900s

Question 52

Dividend signalling hypothesis

Answer 52

Changes reflect managers views about firm earning prospects
increases can send + signal to investors management expects to be able to afford higher dividend
decrease can -ve signal that managers don’t expect earnings to recover so reduce dividend to save cash.

On flip side, an increase in dividend may signal lack of investment opportunities

with a decrease in dividend also done to exploit +NPV opportunities.

These cases may cause a dividend increase/cut to move stock price in the opposite direction