Corporate Finance

Question 1

Depreciation Formula

Answer 1

(Cost - Salvage Value) / years

Question 2

Cashflow Formula

Answer 2

Cash flow = [(Revenue - Cost - Depreciation)(1 - T) + Depreciation

Question 3

Initial investment outlay Formula

Question 4

Afer-tax non-operating cash flows (TNOCF): Formula

Answer 4

TNOCF = Sal_T + NWC_Inv - T(Sal_T -B_T)

= (New salvage proceeds - Old salvage proceeds) + NewWC - Tax (Incremental proceeds - Incremental BV)

Question 5

Capital Budgeting Expansion Steps

Answer 5

Question 6

Replacement project method

Answer 6

Outlay = FC_Inv + NWC_Inv - Sal₀ + T(Sal₀ - B₀ )

Question 7

Effects of Inflation on Capital Budgeting

Answer 7

• Disount nominal (real) cashflows at nominal (real) rate (The WACC already incorporates returns required due to inflation > Cash flow estimates must therefore incorporate inflation > Alternatively, discount real cash flows by the real WACC)
• Unexpected changes in inflation affect project profitability
• Reduces the real tax savings from depreciation
• Decreases value of fixed payments to bondholders
• Affects costs and revenues differently

Question 8

Evaluating Projects with Unequal Lives

Equivalent annual annuity (EAA) method

Answer 8

Calculate [PMT] with PV = PV of project cash flows

FV = 0

Choose higher EAA!

Question 9

Capital Rationing

Answer 9

• Choose the combination with the highest NPV!
• Capital rationing is where a budget constraint is imposed on a manager
• IRRs should not be used under capital rationing as a high IRR project may have a low NPV (e.g. project D)

Question 10

TYpes of merger

Answer 10

1. Acquisition vs Merger
2. Statutory vs. Subsidiary vs. Consolidation
3. Horizontal merger (Economies of scale ) - similar industry
4. Vertical merger (Forward / Backward ) - up and down value chain
5. Conglomerate

Question 11

Form of acquisition (stock vs asset)

Answer 11

Question 12

Reasons for merger

Answer 12

1. Synergy: Most common goal is to reduce costs (economies of scale) and/or increase revenue (cross selling opportunities)
2. Growth: Less risky to merge with existing company than to enter a new market and develop resources internally
3. Increasing market power: Horizontal and vertical integration
4. Acquiring unique capabilities and resources
5. Diversification
6. Bootstrapping: Earnings per share increase, but no economic gain (See example overleaf)
7. Tax considerations: Profitable company might wish to merge with a loss making company to immediately lower its tax liability

Question 13

M&A: Method of payment

Answer 13

1. Stock offer
   
   • Target shareholders receive new shares. They therefore share in the reward and risk following the merger
   • Acquirer is more likely to offer stock if it believes its shares are overvalued
2. Cash offer
   
   • Often accompanied by issuing debt to finance cash offer. Will therefore affect capital structure and cost of capital
   • The more confident the acquirer is of creating synergies the more likely The more confident the acquirer is of creating synergies the more likely they are to offer cash

Question 14

Takeover Tactics: Attitude of management

Friendly vs. Hostile

Answer 14

1. Friendly
   
   • Approach target management. Confidential due diligence leads to definitive merger agreement. After which deals becomes public knowledge and relevant approvals are sought e.g. from shareholders and possibly regulators
2. Hostile
   
   • ​Bear Hug: Direct approach to target board of directors Direct approach to target board of directors – bear hug – and bypass the CEO. Bear hugs are not formal offers, merely an expression of interest
   • Tender offer: Alternatively might approach target shareholders directly
   • Proxy fight: Final approach might be to appeal to target shareholders to replace existing management existing management. Once new management are installed it can then proceed as a friendly merger

Question 15

Pre-Takeover Defences

Answer 15

1. Poison pill: flip-in and flip-over pills
   
   1. Flip-in allows target shareholders the right to buy more shares in the target at a discount thus diluting the ownership of acquirer
   2. Flip-over is similar except it allows the target shareholders to buy shares in the acquiring company at a discount shares in the acquiring company at a discount
2. Poison put: ​Allows bondholders of target to sell back bonds (usually above par) at a pre-determined price
3. Restrictive Takeover Laws: ​Find a State that allows protection to targets Find a State that allows protection to targets
4. Staggered Board: ​Makes a proxy fight that bit harder
5. Restricted voting rights: Once a shareholder achieves a certain level of ownership, e.g. 15% they then cannot vote without Board’s permission they then cannot vote without Board s permission
6. Supermajority voting (e.g. on takeovers 75%)
7. Fair price amendments: If the offer is not deemed a “fair” price then it will not be allowed
8. Golden parachutes (payments to directors)

Question 16

Post-takeover defences

Answer 16

1. Just say no
2. Litigation
3. Greenmail: target agrees to buy back shares that have been acquired by the acquirer as form of compensation for the bid to be dropped acquirer as form of compensation for the bid to be dropped
4. Share repurchase: target buying its own stock (often through debt issuance) makes target share price higher and increases leverage. Bidder will have to increase their offer price whilst at the same time value of the target might be diminished due to higher leverage target might be diminished due to higher leverage
5. Leveraged recapitalisation: Similar to share repurchase. Aim is to buy back shares (but not take company private) and increase leverage
6. Crown Jewel (sells its most valuable assets to reduce its attractiveness)
7. Pac man (target firm then tries to acquire the company that has made a hostile takeover attempt)
8. White knight (friendly’ individual or company acquires a corporation at fair consideration when it is on the verge of being taken over by an ‘unfriendly’ bidder or acquirer)
9. White squire (investor or company that takes a stake in a company to prevent a hostile takeover)

Question 17

Herfindahl-Hirschman Index (HHI)

Answer 17

Squared Market share Post merger = big jumps is not good

Question 18

Merger Analysis

Answer 18

EXAMPLE 8.3!!!!!!!

Target shareholders’ gain = Premium = Price – Pre-bid value

Acquirer’s gain = Synergies - Premium

Post-merger value = Pre-bid value of both + Synergies – Cash paid

Question 19

Empirical results of merger gains

Answer 19

• Target shareholders gain in short run by an average 30% premium and acquirer’s share price falls on average by 1-3%
• On average cash offers tend to increase stock returns for target and acquirer by more than stock offers
• Over longer term (three years following merger) acquirers tend to underperform comparable companies (61% underperform and the average annual return is -4.3%)

Question 20

M&A: Drivers of Value

Answer 20

• Acquirer is successful prior to bid
• Acquirers pay a low premium (i.e. do not over-pay)
• Number of bidders is low (keep premium low)
• Initial market reaction is favorable

Question 21

Voluntary divestitures can be motivated by

Answer 21

1. Poor fit of division
2. Reverse synergy – worth more in parts
3. Poor performance
4. Capital market factors – markets prefer pure play companies markets prefer pure play companies
5. Cash flow factors – divestitures improve cash flow
6. Abandoning the core business – sometimes motivated by desire to leave a mature area and focus on growth opportunities

Question 22

Types of divestures

Answer 22

1. Spin-offs
   
   • Parent creates a new legal entity for a division and distributes shares in the new entity to existing shareholders pro rata. Shareholders now own shares in two companies. Spun-off firm is then run separately – there is no cash inflow from spin from spin -off
2. Split-off: Similar to above except shareholders swap their shares in parent for share in new equity
3. Equity carve-out: Sale of an equity interest in a subsidiary to an outside investor. Often takes form of a public offering – results in cash inflow
4. Voluntary liquidations (Bust-ups): Possible where firm’s net assets are worth more than the equity value. Typically associated with bankruptcy