Corporate Issuers Flashcards
Capital Structure, WACC, & Cost of Financial Distress
Capital Structure combines debt and equity to minimize WACC which will maximize firm value
WACC = W_D * K_D * (1-t) + W_E * K_E
WACC = Debt Weight * Cost of Debt * (1 - Tax Rate) + Equity Weight * Cost of Equity
Cost of financial distress has two factors: Direct/Indirect costs of financial distress and probability of financial distress
Higher Leverage = Higher Costs and Higher Probability of Distress
Modigiliani and Miller (MM) Proposition I and II (Taxes and No Taxes)
No Taxes Assumption:
Proposition I: Value of firm is unaffected by capital structure, Value Levered = Value Unlevered
Proposition II: Cost of equity increases linearly as debt rises, therefore benefit of using more debt is offset by rising equity costs and the firms WACC will not change
r_e = r_u + D/E (r_u - r_d)
Cost of equity = unlevered cost of cap + debt/equity *(unlevered cost of cap - cost of debt)
Taxes Assumption:
Proposition I: Value is maximized at 100% debt, tax shield from debt allows WACC to go down when leverage goes up, V_L = V_U + (t * d)
Value of Levered firm = value of unlevered firm + (tax rate * debt)
Proposition II: WACC is minimized at 100% debt, tax shield provided by debt will minimize WACC
Net Agency Costs & Capital Structure Design
Net Agency Costs: Costs from conflict of interest between manager and investors
Examples: Monitoring costs (costs spent to have good corp governance), bonding costs (costs to have a noncompete agreement in place), asymmetry info (cost of managers having more info than investors)
Capital Structure Design:
If no taxes than cap structure is irrelevant, if taxes use 100% debt
Peaking Order Theory: Finance via least signal to public, use internal funds first, than debt, than issuing outside equity
Static Trade Off Theory: Managers must balance benefit of debt with the costs of financial distress, V_L = V_U +(t * d) - PV(cost of distress)
Value of levered firm = value of unlevered firm + (tax rate * debt) - PV(costs of financial distress)
Consider structure changes overtime and competition when looking at firm
Dividend Types & Dividend Theories
Div Types:
Regular - Cash and periodic
Special - Cash and irregular timing
Liquidating - Retained earnings are paid out or part of firm is sold
Stock - Shares issued, no cash
Stock Split - No change in ownership, just more shares
Div Theories:
MM - Divs don’t matter, they don’t change cost of capital, and investors can create there own dividends by selling shares if they need cash
Div Preference Theory - Investors like consistent, steady divs and CFs
Tax Aversion Theory - Investors prefer share buybacks especially when dividend taxes are higher than capital gains taxes
Divs signal firms future about earnings, unexpected increase is a good sign
Dividend Taxation & Stable Dividend Payout
Dividend Taxation:
Double Taxation: In the US dividends are double taxed, first at the corporate level and than again at the individual level.
Effective Rate = Corp Tax Rate + (1 - Corp Tax Rate) * Individual Rate, being taxed twice but not just addition because getting taxed on a lower base for individual rates
Split Rate Corporate Taxes: Retained earnings taxed higher than divs, this reduced the double taxation effect and encourages dividend payments
Imputation Tax System: Corporate taxed at individual shareholder rate, taxes are attributed to the shareholders
Stable Div Payout: Increase your div payout by the same % each year until at target payout ratio, you decide how many years to take to get to target payout ratio
Share Repurchase Methods, EPS Effects, Dividend Coverage Ratios
Share Repurchase Methods:
Open Market (Flexible, firm can decide when it wants to buy back at attractive prices)
Tender Offer (Quick, firm pays a premium above market price, pro rata if too many people want to sell shares)
Dutch Auction (Slower, set price range, sellers come in and make bids, firm takes highest bid to satisfy the buy back and pays to all at/below that bid)
Direct Negotiation (Buyback from a single shareholder)
EPS/BVPS effect of share buyback, if earnings yield > cash yield than EPS will go up, if using debt to buyback than earnings yield will go down by after tax affect of that debt, tradeoff here is when leverage is up your cost of capital is also up. If price paid for buyback > BVPS than remainng BVPS will go down.
Repurchase shares for tax advantage, good signal, flexibility, prevent dilution from employee share plans, or to increase leverage of firm
Div coverage ratio = NI/Divs Paid
FCFE Coverage Ratio = FCFE/(Divs + Share Repurchases)
ESG & Ownership Variations in Corporations
Ownership (Dispersed, Concentrated, Hybrid):
Dispersed: No controlling shareholder
Concentrated: Controlling shareholder or group that has decision power
Vertical Firm: Owns upstream and downstream, holding controlling stake in operating companies
Horizontal Firm: Two firms with similar business interests hold shares in each other
Dual Share Class: One share class has voting rights, other share class does not
Board of Directors can be single tier (internal/external mix) or two tier where supervisory (external) board oversees management (internal) board
CEO Duality (CEO is chair of the board) can raise concern about monitoring board
ESG: Voluntarily to report, tough to gage usefulness, fixed income looks at downside risk, equity looks at both sides, one of many firm factors
Merger Categories, Types, and Motives
Categories
Statutory: Acquirer absorbs target wholly, all assets/liabs
Subsidiary: Target becomes a sub of acquirer
Consolidation: Two firms merge to form a new firm
Types
Horizontal: Firms in similar business lines merge (most common)
Vertical: Merge with firms up and down stream
Conglomerate: Combine with an unrelated business (Elon with Twitter)
Motives: Synergies, growth, market power increase, tax benefits, diversification, bootstrap earnings (high price/earnings firm buys a low P/E firm for stock, total earnings will not change but the shares will go down so EPS will go up
Firm Life Cycles and Merger Motivation
All firms will be open to horizontal mergers, usually conglomerates happen in early stages or at end, and vertical in middle when trying to scale
Stages of Firm Life Cycles:
Embryonic: New firm/product, high capital needs, low profit, potential, will merge to gain more capital/talent
Growth: Some profits, still low competition, growing sales, merge for capacity and capital
Shakeout: Good profits still but more competition, still opportunity, merge for efficiencies/scale
Mature: High competition, capacity constraints, merge for scale/to cut costs
Decline: Overcapacity, not more interest in product, merge to survive/find new growth opportunities
Transaction Characteristics (Stock vs Asset Purchase) & Payment Method (Cash vs Stock)
Stock Purchase: Buy all of the targets stock, requires majority shareholder approval, no corporate taxes for target but the shareholders will pay tax, acquirer will assume liabs
Asset Purchase: Buy an asset or multiple assets from a firm, doesn’t require approval unless the asset is vital, target will pay corporate taxes on gain on sale but shareholders will not pay an tax and acquirer will not assume liabs
Payment Method can be via cash or stock
Cash: Set gain for the target since payment is in cash, acquirer will assume the risk but will get reward if synergies are greater than expected, acquirer prefers if confident in transaction, wants to keep all of the gain to themselves
Stock: Target assumes some risk as their value is tied to acquirers stock now, they can also reap some reward if the synergies are greater than expected, target prefer if confident in transaction
Management Attitude & Takeover Defenses
Management Attitude:
Friendly = Both sides will work together and process can go smoother
Hostile = Target doesn’t want to be bought, acquirer can either tender offer to shareholders and pay them a premium for their shares or they can proxy the shareholders to vote in a new board that will willingly be acquired
Pre-Offer Defenses: Poison Pill (shareholders gain right to buy more shares if someone tries to acquire), Poison Put (bondholders can demand immediate redemption of their bonds), incorporation in a protective state, stagger board elections, two share classes with different voting rights, supermajority (75%+), fair price agreement in place from 3rd party, golden parachute
Post-Offer Defenses: Say no, litigate, buy your own shares back, take on debt to look unattractive, sell your main asset (crown jewel), white knight (find a friend to buy acquirer), white squire (find a friend to buy minority stack in you so you can’t be taken over)
Valuing a Merger Target (DCF, Comparable Company & Transaction)
DCF: Develop pro forma financials, forecast CFs and terminal value based on these financials, discount back to today for firm value
Advantages: Easy to customize, based on future
Disadvantage: Can’t apply to negative CF, extremely dependent on inputs, big risk if discount rate or terminal value is wrong, garbage in garbage out
Comparable Company: Look for a similar company to the one that you are buying that has data available, compare via ratios and size and add in a takeover premium
Adv: Data available, fundamentally sound, uses market values
DisAdv: Market value could be wrong, premium tough to estimate, no synergy value factored in
Comparable Transaction: Look at a similar transaction to the one you are buying that has data available, compare via ratios and size to determine value
Adv: No premium estimation as its already baked in, uses actual values transacted on in market
DisAdv: Assumes past mergers are accurate, data may be old, no synergy value factored in
Merger Bid Formula & Types of Restructuring
Post Merger Valuation = Value of Acquirer + Value of Target + Synergies - Costs
Gain to Target = Price received - Value of target before merger/speculation
Gain to Acquirer = Synergies - (Price Paid - Value of target) = Synergies + value of target - price paid
Restructuring Types:
Sale of division to 3rd party for cash
Equity carve out (Sub goes public, parent still owns some)
Spin-off (New company formed, shareholders have shares of both parent and new)
Split-off (New company formed, shareholders pick between new firm and parent shares)
Liquidation (selling off assets)
Restructuring usually happens when change is needed or cash infusion is needed
Expansion Projects & Replacement Projects CFs
Three Main Components for both types of projects: Initial outlay, After Tax ongoing CF and after tax terminal value
Initial Outlay = Purchase price + transportation + installation + ∆working capital
Ongoing after tax operating CF = (S-C)(1-T) + (TD), TD is depreciation tax shield
Cash Flows = (Sales - Cash Operating Costs) (1 - Tax) + (Tax * Depreciation)
Terminal Year after tax salvage value = salvage value + ∆working capital recaptured - Tax(Salvage - BV), if Salvage > BV than pay taxes on gain, if Salvage < BV than you get a tax credit
Replacement Projects: Same as expansion with two main differences:
Reduce initial outlay by after tax sale proceeds
Only use the change in depreciation from old to new, not entire depreciation,
Ignore sunk costs and financing costs with asset purchase (these are included in WACC)
Include effects on other areas of business (cannibalism) and opportunity cost of using firms assets
Mutually Exclusive Projects, Project Risk Analysis, Capital Rationing, Real Options
Mutually exclusive project with unequal lives: Not always the highest NPV, need to factor in time to get to that NPV, factor in that projects can repeat (replacement chain)
Equivalent Annual Annuity (EAA) is another way to think of it, take the NPV of each project and the time it takes to get to that NPV and figure out what your annuity payment would be, looking to achieve the highest payment
Project Risk Analysis:
Sensitivity Analysis: Changing one variable to see how sensitive the NPV is to that variable, more sensitive the higher the risk in the NPV
Scenario Analysis: Take base case, worst case, and best case, assign %s to each case and find the std dev to see how risky the NPV is
Monte Carlo: Simulation, take std dev to get riskiness
Capital Rationing: Ideally firm would like to invest in all positive NPV projects but there is only so much capital to go around, need to decide on the best projects to maximize the firm wide NPV
Real Options: Decisions that management have on projects such as timing (being able to decide to continue or not based on new info that was only recently available), abandonment, expansion, flexibility (price setting and production quotas), fundamental option to continue project or sell assets
Calc options value by taking NPV with option and without option and finding difference
