Corporate Finance Flashcards
inflation affects capital budgeting analysis
- Analyzing nominal or real cash flows. Nominal cash flows reflect the impact of inflation, while real cash flows are adjusted downward to remove inflation effects. Although either type of cash flow can be used in the capital budgeting process, it is important to match the type of cash flows with the discount rate. Nominal cash flows should be discounted at a nominal discount rate, while real cash flows should be discounted at a real discount rate.
- Changes in inflation affect project profitability. If inflation is higher than expected, future project cash flows are worth less, and the value of the project will be lower than expected. The opposite is also true, however. If inflation turns out to be lower than originally expected, future cash flows from the project will be worth more, effectively increasing the project’s value.
- Inflation reduces the tax savings from depreciation. If inflation is higher than expected, the firm’s real taxes paid to the government are effectively increased because the depreciation tax shelter is less valuable. This is because the depreciation charge, which is based upon the asset’s purchase price, is less than it would be if recalculated at current (i.e., inflated) prices.
- Inflation decreases the value of payments to bondholders. Bondholders receive fixed payments that are effectively worth less as inflation increases. This means that higher than expected inflation effectively shifts wealth to issuing firms at bondholders’ expense.
- Inflation may affect revenues and costs differently. If prices of goods change at a different rate than the prices for inputs used to create those goods, the firm’s after-tax cash flows may be better or worse than expected.
The claims valuation and economic profit valuation models
The claims valuation approach looks at cash flows to equity holders and debt holders separately, while the economic profit method looks at cash flows from the perspective of all suppliers of capital, so debt holders’ concerns are included in both methods. Also, the discount rate used with the economic profit method is the WACC, while the claims valuation approach considers the cost of equity and the cost of debt separately, so the cost of debt is a factor in both calculations.
An abandonment option
An abandonment option should be exercised when the abandonment value for a project is greater than the discounted present value of the remaining cash flows from the project.
Accounting income vs. economic income
A project’s accounting income is the reported net income on a company’s financial statements that results from an investment in a project. Accounting income will differ from economic income because:
- Accounting depreciation is based on the original cost (not market value) of the investment.
- Financing costs (e.g., interest expense) are considered as a separate line item and subtracted out to arrive at net income. In the basic capital budgeting model, financing costs are reflected in the WACC.
The least likely goal of an optimal capital structure decision is to target the amount of financial leverage that:
a) maximizes the stock price?
b) maximizes the EPS?
c) minimizes the WACC?
At the optimal capital structure the firm will minimize the WACC, maximize the share price of the stock and maximize the value of the firm. The capital structure that maximizes EPS will generally contain more debt than the capital structure that maximizes firm value and minimizes WACC.
Agency cost of equity
Agency costs of equity refer to the costs associated with the conflicts of interest between managers and owners.
Net agency costs of equity have three components
Monitoring costs are the costs associated with supervising management and include the expenses associated with making reports to shareholders and paying the board of directors. Note that strong corporate governance systems will reduce monitoring costs.
Bonding costs are assumed by management to assure shareholders that the managers are working in the shareholders’ best interest. Examples of bonding costs include the premiums for insurance to guarantee performance and implicit costs associated with non-compete agreements.
Residual losses may occur even with adequate monitoring and bonding provisions because such provisions do not provide a perfect guarantee.
According to agency theory, the use of debt forces managers to be disciplined with regard to how they spend cash because they have less free cash flow to use for their own benefit. It follows that greater amounts of financial leverage tend to reduce agency costs.
Forms of Integration - statutory merger, subsidiary merger, consolidation
In a statutory merger, the acquiring company acquires all of the target’s assets and liabilities. As a result, the target company ceases to exist as a separate entity. Note that in a statutory merger, the target company is usually smaller than the purchaser, but this is not always the case.
In a subsidiary merger, the target company becomes a subsidiary of the purchaser. Most subsidiary mergers typically occur when the target has a well-known brand that the acquirer wants to retain (e.g., Proctor and Gamble buying Gillette).
With a consolidation, both companies cease to exist in their prior form, and they come together to form a completely new company. Consolidations are common in mergers when both companies are of a similar size.
Common motivation behind M&A
- Synergies
- Gaining access to unique capabilities
- diversification
- bootstrapping EPS
- Personal benefits for managers
- tax benefits
- unlocking hidden value
- achieving international business goals
- -> taking advantage of market inefficiencies
- -> working around disadvantageous government policies
- -> use technology in new markets
- -> product differentiation
- -> provide support to existing multinational clients
Bootstrapping
Bootstrapping is a way of packaging the combined earnings from two companies after a merger so that the merger generates an increase in the earnings per share of the acquirer, even when no real economic gains have been achieved.
The “bootstrap effect” occurs when a high P/E firm (generally a firm with high growth prospects) acquires a low P/E firm (generally a firm with low growth prospects) in a stock transaction. Post-merger, the earnings of the combined firm are simply the sum of the respective earnings prior to the merger
However, by purchasing the firm with a lower P/E, the acquiring firm is essentially exchanging higher-priced shares for lower-priced shares. As a result, the number of shares outstanding for the acquiring firm increases, but at a ratio that is less than 1-for-1. When we compute the EPS for the combined firm, the numerator (total earnings) is equal to the sum of the combined firms, but the denominator (total shares outstanding) is less than the sum of the combined firms. The result is a higher reported EPS, even when the merger creates no additional synergistic value.
Forms of acquisition - stock purchase
In a stock purchase, the acquirer gives the target firm’s shareholders cash and/or securities in exchange for shares of the target company’s stock. There are several important issues regarding stock purchases of which you should be aware.
With a stock purchase, it is the shareholders that receive compensation, not the company itself. As a result, shareholders must approve the transaction with at least a majority shareholder vote (sometimes it’s more than a majority, depending on the law where the merger takes place). Winning shareholder approval can be time consuming; but if the merger is hostile, dealing directly with shareholders is a way to avoid negotiations with management.
Also, shareholders will bear any tax consequences associated with the transaction. Shareholders must pay tax on gains, but there are no taxes at the corporate level. If the target company has accumulated tax losses, a stock purchase benefits the shareholders because under U.S. rules, the use of a target’s tax losses is allowable for stock purchases, but not for asset purchases.
Finally, most stock purchases involve purchasing the entire company and not just a portion of it. This means that not only will the acquirer gain the target company’s assets, but it will also assume the target’s liabilities.
Forms of acquisition - asset purchase
In an asset purchase, the acquirer purchases the target company’s assets, and payment is made directly to the target company.
Unless the assets are substantial (e.g., more than 50% of the company), shareholder approval is generally not required.
Also, because payment is made to the company, there are no direct tax consequences for the shareholder. The target company will pay any capital gains taxes associated with the transaction at the corporate level.
Asset purchase acquisitions usually focus on specific parts of the company that are of particular interest to the acquirer, rather than the entire company, which means that the acquirer generally avoids assuming any of the target company’s liabilities. However, an asset purchase for the sole purpose of avoiding the assumption of liabilities is generally not allowed from a legal standpoint. Key Differences Between Forms of Acquisition summarizes the key differences between stock purchase and an asset purchase.
Method of payment
Securities offering and cash offers.
When an acquirer is negotiating with a target over the method of payment, there are three main factors that should be considered:
Distribution between risk and reward for the acquirer and target shareholders. In a stock offering, since the target company’s shareholders receive new shares in the post-merger company, they share in the risk related to the ultimate value that is realized from the merger. In a cash offering, all of the risk related to the value of the post-merger company is borne by the acquirer. As a result, when the acquirer is highly confident in the synergies and value that will be created by the merger, it is more inclined to push for a cash offering.
Relative valuations of companies involved. If the acquirer’s shares are considered overvalued by the market, the acquirer is likely to want to use its overpriced shares as currency in the merger transaction. In fact, investors sometimes interpret a stock offering as a signal that the acquirer’s shares may be overvalued.
Changes in capital structure. Different payment structures have an impact on the acquiring firm’s capital structure. If the acquirer borrows money to raise cash for a cash offering, the associated debt will increase the acquirer’s financial leverage and risk. Issuing new stock for a securities offering can dilute the ownership interest for the acquirer’s existing shareholders.
Bear Hug
Hostile merger offers typically follow a much different process than friendly mergers. If the target company’s management does not support the deal, the acquirer submits a merger proposal directly to the target’s board of directors in a process called a bear hug.
If the bear hug is unsuccessful, the next step is to appeal directly to the target’s shareholders using one of two methods—a tender offer or a proxy battle.
In a tender offer, the acquirer offers to buy the shares directly from the target shareholders, and each individual shareholder either accepts or rejects the offer.
In a proxy battle, the acquirer seeks to control the target by having shareholders approve a new “acquirer approved” board of directors. A proxy solicitation is approved by regulators and then sent to the target’s shareholders. If the shareholders elect the acquirer’s slate of directors, the new board may replace the target’s management and the merger offer may become friendly.
Pre-Offer Defense Mechanisms
Poison pill. Poison pills are extremely effective anti-takeover devices and were the subject of many legal battles in their infancy. In its most basic form, a poison pill gives current shareholders the right to purchase additional shares of stock at extremely attractive prices (i.e., at a discount to current market value), which causes dilution and effectively increases the cost to the potential acquirer. The pills are usually triggered when a shareholder’s equity stake exceeds some threshold level (e.g., 10%). Specific forms of a poison pill are a flip-in pill, where the target company’s shareholders have the right to buy the target’s shares at a discount, and a flip-over pill, where the target’s shareholders have the right to buy the acquirer’s shares at a discount. In case of a friendly merger offer, most poison pill plans give the board of directors the right to redeem the pill prior to a triggering event.
Poison put. This anti-takeover device is different from the others, as it focuses on bondholders. These puts give bondholders the option to demand immediate repayment of their bonds if there is a hostile takeover. This additional cash burden may fend off a would-be acquirer.
Restrictive takeover laws. Companies in the United States are incorporated in specific states, and the rules of that state apply to the corporation. Some states are more target friendly than others when it comes to having rules to protect against hostile takeover attempts. Companies that want to avoid a potential hostile merger offer may seek to reincorporate in a state that has enacted strict anti-takeover laws. Historically, Ohio and Pennsylvania have been considered to provide target companies with the most protection.
Staggered board. In this strategy, the board of directors is split into roughly three equal-sized groups. Each group is elected for a 3-year term in a staggered system: in the first year the first group is elected, the following year the next group is elected, and in the final year the third group is elected. The implications are straight-forward. In any particular year, a bidder can win at most one-third of the board seats. It would take a potential acquirer at least two years to gain majority control of the board since the terms are overlapping for the remaining board members. This is usually longer than a bidder would want to wait and can deter a potential acquirer.
Restricted voting rights. Equity ownership above some threshold level (e.g., 15% or 20%) triggers a loss of voting rights unless approved by the board of directors. This greatly reduces the effectiveness of a tender offer and forces the bidder to negotiate with the board of directors directly.
Supermajority voting provision for mergers. A supermajority provision in the corporate charter requires shareholder support in excess of a simple majority. For example, a supermajority provision may require 66.7%, 75%, or 80% of votes in favor of a merger. Therefore, a simple majority shareholder vote of 51% would still fail under these supermajority limits.
Fair price amendment. A fair price amendment restricts a merger offer unless a fair price is offered to current shareholders. This fair price is usually determined by some formula or independent appraisal.
Golden parachutes. Golden parachutes are compensation agreements between the target and its senior management that give the managers lucrative cash payouts if they leave the target company after a merger. In practice, payouts to managers are generally not big enough to stop a large merger deal, but they do ease the target management’s concern about losing their jobs.
