Corporate Issuers Flashcards
1
Q
4.1 Analysis of Dividends and Share Repurchases
A
The candidate should be able to:
describe the expected effect of regular cash dividends, extra dividends, liquidating dividends, stock dividends, stock splits, and reverse stock splits on shareholders’ wealth and a company’s financial ratios
compare theories of dividend policy and explain implications of each for share value given a description of a corporate dividend action
describe types of information (signals) that dividend initiations, increases, decreases, and omissions may convey
explain how agency costs may affect a company’s payout policy explain factors that affect dividend policy in practice
calculate and interpret the effective tax rate on a given currency unit of corporate earnings under double taxation, dividend imputation, and split-rate tax systems
compare stable dividend with constant dividend payout ratio, and calculate the dividend under each policy
describe broad trends in corporate payout policies compare share repurchase methods
calculate and compare the effect of a share repurchase on earnings per share when 1) the repurchase is financed with the company’s surplus cash and 2) the company uses debt to finance the repurchase
calculate the effect of a share repurchase on book value per share
explain the choice between paying cash dividends and repurchasing shares
calculate and interpret dividend coverage ratios based on 1) net income and 2) free cash flow
identify characteristics of companies that may not be able to sustain their cash dividend
2
Q
Dividends: Forms and Effects on Shareholder Wealth and Financial Ratios
A
Dividends are declared by the company’s board, although these decisions may be subject to a shareholder vote.
3
Q
After a dividend has been declared, a stock will trade at a price that reflects the right to receive this dividend until the ex-dividend date, which is the first date that the shares trade without this right.
A
For example, all else equal, a stock with a $5 declared dividend that closed the previous session at $70 will open at $65 on its ex-dividend date.
Buy share before ex-dividend date = Receive the dividend
Buy share after ex-dividend date = Do Not receive the dividend
4
Q
Regular Cash Dividends :
In North America, dividend payments are usually made each quarter. Australian and Japanese companies typically pay dividends semiannually. In countries such as Germany and Thailand, investors tend to receive a single dividend payment each year.
A
Cutting Dividend = Sign of weakness
Therefore, companies tend to seek growth or maintain dividend payments size
5
Q
Extra or Special (Irregular) Dividends :
Cash dividend not paid on a regular schedule. Some companies, particularly those that operate in cyclical industries, have used these dividends to distribute funds in periods of strong earnings after having conserved their cash during downturns.
A
Some companies have dividend policies that explicitly state a minimum share of earnings to be distributed. In such cases, any payments in excess of this payout ratio can be considered to be extra dividends.
6
Q
Liquidating Dividends :
Return of capital rather than a distribution of earnings
A
Requirements to be classified as such:
1- A company goes out of business and distributes its net assets to shareholders.
2- A portion of a business is sold and the proceeds are distributed to shareholders.
3- The amount of the dividend exceeds the value of the company’s accumulated retained earnings.
7
Q
Stock Dividends :
Distribution increases the number of shares outstanding without affecting the company’s total market value. Both market value and earnings are reduced on a per share basis but, because the changes are proportional, the P/E ratio is unaffected.
A
Generally not taxable to shareholders, do not impact an investor’s total cost basis (they merely reduce the cost basis per share).
8
Q
Cash dividends reduce liquidity ratios and increase leverage
A
Stock dividend does not affect the company’s balance sheet or income statement –> Ratios unchanged
9
Q
- Incentivizing Long-Term Investors:
Companies that pay regular stock dividends demonstrate a consistent return of value to shareholders. This regularity signals financial health and stability, appealing to long-term investors who value predictable returns.
By attracting and retaining long-term investors, who are less likely to sell shares during market volatility, the company experiences a more stable stock price. This stability can reduce the company’s cost of equity, a key component of its overall cost of capital.
- Increasing Stock Liquidity:
Stock dividends, especially if they are in the form of stock splits or stock splits in disguise, increase the number of shares outstanding. This larger number of shares allows for more frequent transactions, thereby improving the stock’s liquidity.
Liquidity is attractive to investors because it enables them to buy or sell shares easily without significantly affecting the stock’s market price. Higher liquidity can lead to reduced trading costs and tighter bid-ask spreads.
- Reducing Price Volatility:
A higher number of shares outstanding often results in smaller price increments for each trade, especially if the absolute stock price is lower after a stock dividend or split.
Lower price increments and increased liquidity make it harder for individual trades to cause large price swings, thereby reducing the stock’s price volatility.
Reduced volatility increases investor confidence, which can further attract stable, long-term investment.
- Keeping Share Prices Attractive:
Some companies issue stock dividends to keep their share price within a range that is psychologically or practically appealing to retail and institutional investors. For example:
A lower-priced stock (e.g., $50 instead of $500) may attract more retail investors who might perceive the lower price as more affordable.
Certain institutional investors have mandates to invest in stocks within specific price ranges, so maintaining an optimal price level increases the stock’s marketability.
A
10
Q
Stock Splits :
Often announced after a stock has risen in value as a way to keep the price within a desirable range. Investors often interpret stock splits as a positive indicator of the issuer’s prospects.
A
A two-for-one stock split is essentially the same as a 100% stock dividend. Measures such as market value and earnings will be reduced by half on a per share basis, leaving the P/E ratio unchanged.
11
Q
Assuming a constant payout ratio, the dividend yield (dividends/price per share) will be similarly unaffected.
A
12
Q
The main difference is with respect to their accounting treatment. A stock dividend transfers retained earnings to contributed capital. A stock split does not.
A
13
Q
Reverse stock splits are not as common –> reduce the number of shares outstanding and produce a corresponding increase in the share price
A
Listed companies may use these transactions to maintain a minimum share price.
14
Q
Dividend Policy and Company Value and Other Theoretical Issues
A
15
Q
Dividend Policy Does Not Matter :
Investors could construct their own “homemade” dividend policy. If a company’s dividends are too high, the investor could use the excess to purchase more shares. If the company’s dividends are too low, the investor could sell shares to make up the deficit.
But in the real world there are taxes and transactions costs
A
In 1961, Modigliani and Miller proposed that dividend policy will not impact the price of a company’s stock or its cost of capital in a perfect capital market with no taxes, no transaction costs, and symmetric information among all investors.
16
Q
Dividend Policy Matters: The Bird in the Hand Argument :
Some argue that investors would prefer a dollar of dividends over a dollar of potential capital gains because dividends are less risky.
A
Shareholders would require a lower return from companies that pay dividends. This lowers the cost of capital for those companies, thereby increasing their share prices.
17
Q
Dividend Policy Matters: The Tax Argument :
Many countries tax dividends at a higher rate than capital gains. In these countries, investors paying taxes will have an incentive to prefer companies with low dividends.
A
18
Q
The Information Content of Dividend Actions –> Signaling :
Dividends can be used to send signals. For example, by announcing that a company will be increasing its dividend, management is signaling its confidence that there will be sufficient cash flows to make these payments. It is not a signal that a company can afford to send without having the earnings growth to back it up.
A
Borrowing to pay dividends is an unsustainable strategy… So it could be a sign of genuine confidence
19
Q
It is possible to send a positive signal with a dividend cut. In theory, companies can choose to cut dividends in order to preserve cash for positive internal opportunities. Indeed, there are examples of companies that have successfully used the funds that accumulated from a temporary dividend reduction to invest in projects that improved their long-term prospects.
A
Investors MUST find the company’s plans to be credible for this to work
20
Q
On the contrary, initiate regular dividends out of the blue can be interpreted as an admission that a company lacks new profitable investment opportunities.
A
21
Q
Agency Costs and Dividends as a Mechanism to Control Them :
Agency costs arise due to the separation of managers and owners. Managers have an incentive to maximize their own welfare at the expense of the owners (because of information asymetry).
A
Managers would be willing to undertake projects with negative net present values even though this is detrimental for the owners, because of their will to grow the business .
Dividends increase the conflict between shareholders and bondholders (less cash for the company to pay its debt obligations). Covenants in the bond indenture can reduce this conflict, such as limiting dividends to a specified percentage of earnings.
22
Q
We know that dividend policy does matter in the real world. However, because company valuations can be affected by many different factors, it is difficult to conclusively identify the exact nature of the relationship between dividends and value.
A
23
Q
Faster-growing companies tend to pay few (if any) dividends. Larger, more mature companies have dividend payout policies that are influenced by considerations such as taxes, regulations, laws, traditions, signaling, and ownership structure. Analysts must evaluate whether a company’s dividend policy is consistent with these factors.
A
24
Q
Factors Affecting Dividend Policy in Practice :
1- Investment opportunities
2- Expected volatility of future earnings
3- Financial flexibility
4- Tax considerations
5- Flotation costs
6- Contractual and legal restrictions
A
25
Investment Opportunities : Depending on the nature of a company's industry, there may be a high level of urgency to make capital investments in order to adapt to changing market conditions. Companies that operate in more stable industries (e.g., utilities) typically have fewer investment opportunities and tend to be better positioned to maintain higher dividend payout ratios.
retained earnings to invest in positive NPV projects
26
The Expected Volatility of Future Earnings :
Companies prefer to base dividends on long-run sustainable earnings rather than short-term fluctuations.
27
Financial Flexibility : Companies often choose to buy back shares as a means of distributing cash to their shareholders without creating the implicit commitment that comes with paying a regular dividend.
28
Tax Considerations : must consider whether dividends are the most tax-efficient method of distributing cash to their shareholders.
29
Taxation Methods :
1- Double Taxation : Companies are taxed on their pretax earnings and shareholders then are taxed on the dividend
2- Imputation : Dividends are taxed at the shareholder’s tax rate. Individual shareholders receive a tax credit, known as a franking credit, if their marginal tax rate is less than the corporate tax rate. Else, they only pay tax based on the difference with the corporate rate.
Split-rate: Dividends are taxed at a lower rate than the earnings retained. Dividends are taxed as ordinary income for investors. The effective tax rate on dividends is calculated with the same formula used under a double taxation system, but the lower corporate tax rate for dividend distributions is applied
30
Investors will likely prefer dividends if the tax rate on dividends is less than the tax rate on capital gains. But investors still may prefer low dividend rates because they can time the capital gains taxes by choosing when to sell.
Tax-exempt institutions (pensions funds, endowments) = indifferent
31
Flotation Costs:
When issuing new stock ;
1) The explicit fees paid to entities such as investment bankers and auditors
2) The implicit cost associated with the price impact of increasing the number of shares outstanding.
More expensive for smaller companies.
Companies tend to avoid relying on equity as capital (more expensive and lose control)
Avoided by paying less in dividends, thus having more cash on hand and therefore no issuing of equity.
32
Contractual and Legal Restrictions :
Brazil, mandate dividend payments. Other countries, such as the United States, prohibit the payment of liquidating dividends that would impair a company's capital.
33
Stable Dividend Policy :
Under this policy, dividends are not meant to fluctuate with short-term earnings, so investors have a high level of certainty about future payments.
Increases steadily over time in line with long-term growth projections.
34
Constant Dividend Payout Ratio Policy :
A constant percentage of current earnings is used to calculate the dividends. This is not a common practice because it results in volatile dividends.
35
Global Trends in Payout Policy :
Dividend policies vary significantly across countries and regions. It can even vary in developped countries.
Shares repurchases have become more popular.
Dividend payments and payout ratios have increased because dividend-paying firms tend to be much larger than companies that do not pay dividends.
Ex: (Asia companies pay more now, US pays less than EU, etc.)
36
2 distinct tiers of companies :
1) Large, profitable companies with relatively few growth opportunities have actually increased their cash dividend payments in real terms and maintained stable payout ratios.
2) New companies, often based in the technology sector, have tended to opt to invest in R&D or use share repurchases rather than paying cash dividends.
Consistent whith theory : dividend policies over time to adapt to investor preferences.
37
Increased corporate disclosure requirements are associated with fewer dividend initiations and increases. As information asymmetry and agency problems have been reduced, companies have less need to use dividends as a signal of their commitment to transparency.
38
[Quiz - Impact of Dividend Payments on Default Risk and Agency Conflicts]
1- Overview of the Concept
-- Proposal #4 refers to the initiation of a regular cash dividend. In a firm with both debt and equity financing, this can alter default risk and agency conflicts depending on how it affects available cash and stakeholder incentives.
2- Relationship Between Dividends and Capital Structure
-- Yeta’s target capital structure is 40% debt and 60% equity. This implies fixed obligations to bondholders that must be serviced through cash flow.
-- Cash dividends reduce the firm's cash reserves, which are essential to meeting debt payments and unexpected obligations.
3- Default Risk Consequences
-- Paying cash dividends depletes cash available for bond interest and principal repayment.
-- This increases the probability of default, particularly if future cash flows decline or volatility increases.
-- Hence, initiating regular dividends, all else equal, increases default risk.
4- Agency Conflicts
-- Between Shareholders and Bondholders:
--- Dividends may increase this conflict. Cash that could have been used to reduce leverage or reinvest in the business is transferred to shareholders.
--- This is seen as a transfer of wealth from bondholders to shareholders, raising the riskiness of the firm’s debt and increasing required yields or reducing creditworthiness.
-- Between Shareholders and Managers:
--- Dividends reduce the free cash flow available to managers, limiting their ability to overinvest or engage in empire-building.
--- Thus, dividend payments may reduce (not increase) shareholder–manager agency conflicts.
Key Takeaways
-- Cash dividends increase the default risk of a company’s debt by reducing liquidity.
-- They increase agency conflicts between shareholders and bondholders by transferring wealth to shareholders.
-- They decrease agency conflicts between shareholders and managers by limiting managerial discretion over free cash flows.
39
Shares that are repurchased may be retired (canceled shares) or classified as treasury shares if it is possible that they will be reissued later.
40
Share Repurchase Methods :
1) Buy in the open market: If trades are timed to minimize market impact, this can be a cost-effective method of buying back shares that management believes to be undervalued.
2) Buy back a fixed number of shares at a fixed price : If shareholders offer to sell more than the fixed amount, the company will typically execute the repurchase on a pro rata basis. The primary advantage of this method is that the repurchase can be executed relatively quickly.
3) Dutch auction: The company specifies a range for the price it is willing to pay to repurchase its shares. Shareholders indicate how many shares they are willing to sell and the minimum sale price they will accept.
4) Repurchase by direct negotiation : The practice of paying a premium to prevent a takeover bid is known as greenmail. However, if a major shareholder has acute liquidity needs, companies can use this method to repurchase shares at a discount to their market value.
41
[Comparison of Share Repurchase Methods and Dutch Auction Benefits]
1- Overview of Share Repurchase Methods
-- Companies use different methods to return capital to shareholders via repurchase programs.
-- The chosen method affects cost, flexibility, execution speed, and signaling impact.
2- Open Market Repurchase
-- Shares are bought back on the secondary market at prevailing prices.
-- 1- Advantages:
--- Provides high flexibility in timing and quantity.
--- Minimal market disruption.
-- 2- Disadvantages:
--- Slow execution pace.
--- Weak market signal compared to other methods.
3- Fixed Price Tender Offer
-- Company offers to repurchase a fixed number of shares at a set price, often above market.
-- 1- Advantages:
--- Fast execution and price certainty.
--- Sends strong signal of confidence to the market.
-- 2- Disadvantages:
--- Requires premium pricing, increasing repurchase cost.
--- All accepted shares are bought at the same high price.
4- Dutch Auction Repurchase
-- Company defines a price range and shareholders bid within it; clearing price is set where target quantity is met.
-- 1- Advantages:
--- Shareholder-driven price discovery.
--- May lead to lower average repurchase cost than fixed-price offer.
-- 2- Disadvantages:
--- More complex and slower execution than fixed offers.
--- Still less flexible than open market repurchases.
5- Direct Negotiation
-- Company privately negotiates share repurchase from specific shareholder(s).
-- 1- Advantages:
--- Efficient for repurchasing large blocks quickly.
--- Avoids open market signaling.
-- 2- Disadvantages:
--- Not inclusive for all shareholders.
--- Potential fairness concerns.
42
Financial Statement Effects of Repurchases
Share repurchases affect both the balance sheet and income statement. Reducing the number of outstanding shares should increase earnings per share (EPS), unless the funds used to repurchase the shares were raised by issuing relatively high-cost debt.
43
Changes in Earnings per Share :
If the net income stays the same, the earnings per share (EPS) will increase after a share repurchase because there are fewer shares outstanding.
Share repurchases made with borrowed funds can increase, decrease, or not affect EPS, depending on the after-tax cost of funds used to finance the buyback and earnings yield.
44
If the earnings yield is lower than the after-tax cost of the funds, the EPS will decrease.
If the earnings yield is equal to the after-tax cost of the funds, the EPS will remain unchanged.
If the earnings yield is greater than the after-tax cost of the funds, the EPS will increase.
Earnings Yield is a measure of how much a company earns relative to the market price of its stock. It tells us how much return the company is generating from its current earnings relative to the stock price.
When comparing Earnings Yield to the After-Tax Cost of Borrowing, the company assesses whether using debt to repurchase shares will be accretive (increase EPS) or dilutive (decrease EPS).
Earnings Yield= Market Price Per Share /
Earnings Per Share (EPS)
or
Earnings Yield= 1 / P/E Ratio
45
It is important to note that an increase in EPS does not necessarily imply an increase in shareholders’ wealth.
The same cash used to repurchase the shares could have been paid out as a dividend.
46
Changes in Book Value per Share:
If the market price per share is greater (less) than its book value per share, a stock repurchase will decrease (increase) the book value per share.
You would take the book value (outstanding shares * Book value per share) - The cost of borrow
then divide / by
Numbers of shares outstanding - numbers of shares repurchased
will equal =
New Book Value per Share
47
[Quiz - Book Value per Share Impact of Share Repurchase]
1- Overview of the Concept
-- Share repurchases affect the book value per share (BVPS) depending on whether shares are bought back above or below the current BVPS. If repurchased below the current BVPS, the remaining shareholders benefit from an increase in BVPS.
2- Formula and Calculation
-- Formula: "BVPS = Book Value of Equity ÷ Number of Shares Outstanding"
-- Given: --- Current BVPS = USD25.60
--- Shares Outstanding = 100 million
--- Book Value of Equity = 25.60 × 100 million = USD2,560 million
--- Share Repurchase Amount = USD40 million
--- Share Price = USD20.00
--- Shares Repurchased = 40 ÷ 20 = 2 million
--- New Equity Value after Repurchase = 2,560 - 40 = USD2,520 million
--- New Shares Outstanding = 100 million - 2 million = 98 million
-- BVPS After Repurchase = 2,520 ÷ 98 = USD25.71
3- Impact Analysis
-- Because the repurchase is at a price below BVPS (USD20 < USD25.60), it increases BVPS.
-- This is a textbook example of accretive buybacks, where value is transferred to remaining shareholders.
Key Takeaways
-- Share repurchases below BVPS increase BVPS.
-- Repurchasing shares reduces equity and number of shares, but the BVPS impact depends on repurchase price vs. existing BVPS.
-- In this case, BVPS increases to USD25.71 post-repurchase.
48
Cash Dividends:
When a company pays a cash dividend, it distributes its earnings directly to all shareholders on a per-share basis.
The total shareholder wealth remains unchanged because the decrease in the company's cash (an asset) is offset by the cash received by shareholders.
Share Repurchases:
In a share repurchase, the company buys back shares, reducing the number of shares outstanding.
This benefits the remaining shareholders because their ownership percentage in the company increases, assuming the repurchase price reflects the fair value of the shares.
Ignoring the tax and information effects, both should have the same effect on shareholder wealth. However, if shares are repurchased at a premium, wealth will be transferred from existing shareholders to the seller.
49
When a company repurchases its shares at a price above fair value (premium):
Benefit to Selling Shareholders:
Shareholders who sell their shares receive the premium, increasing their personal wealth compared to the fair value of the shares.
Cost to Remaining Shareholders:
The company uses more of its cash or resources to pay the premium, reducing the value of the firm for the remaining shareholders.
Since fewer shares remain outstanding, each remaining share represents a slightly smaller ownership claim on the reduced firm value. This results in a transfer of wealth from remaining shareholders to the selling shareholders.
If there's a premium in the repurchase, the MV value per share will be lower than before the repurchase
50
Share repurchase announcements are often bullish --> management only buys back shares when they consider them to be underpriced
The impact on shareH value should be the same as equivalent dividend --> Theorical not in the real world
51
Share repurchases are done because:
1- Potential tax advantages : if the tax rate on capital gains is less than the tax rate on dividends.
2- Share price support/signaling : Principal / Agent relationship (management has more info). Either management thinks price is undervalued or it can show a lack of new profitable investment opportunities.
3- Financial flexibility: Not expected to continue indefinitely (obviously) and no obligation to fully execute share repurchase plans that have been announced.
4- Offsetting dilution from employee stock options
5- Adjusting capital structure : Repurchasing shares is a way to increase leverage.
6- Increasing earnings per share : * this does not necessarily indicate an increase in shareholder value.
52
Share repurchases typically increase when the economy is strong and companies have excess cash. Similarly, share repurchase activity tends to be curtailed during economic downturns.
53
The shareholders decided if they want to participate in the share repurchase. Meaning the company does not distribute the cash proportionally ; like dividends.
54
As a general rule, dividend-paying companies target a payout ratio (dividends/net income) of 40% to 60% over the course of a business cycle. Note that this range translates to a dividend coverage ratio (net income/dividends) between 1.67 and 2.50.
55
To calculate FCFE, start with operating cash flows (CFO), then subtract fixed capital investment, and add back any net borrowing.
A company's FCFE coverage ratio can be interpreted as follows:
- If the ratio is equal to 1, the company is distributing all available cash to shareholders.
- If the ratio is significantly greater than 1, the company is keeping some earnings to enhance liquidity.
- If the ratio is significantly less than 1, the company is borrowing cash to pay dividends, thereby decreasing liquidity. This is unsustainable because the company is paying out more than it can afford.
56
A very high dividend yield (e.g., >10%) compared with a company's past record and current bond yields is often a warning sign that investors are expecting the company to reduce its dividend. Empirical studies show that the highest-yielding stocks tend to underperform in subsequent periods.
57
Using a Dutch auction mechanism allows companies to identify the minimum price that shareholders are willing to accept to sell back their shares.
Dutch auctions allow repurchases to be completed reasonably quickly, but generally not as quickly as fixed price tender offers.
Dutch auctions do not grant companies any greater flexibility in repurchasing shares compared to fixed price tender offers. Both methods allow less flexibility than open market repurchases.
58
4.2 ESG Considerations in Investment Analysis
describe global variations in ownership structures and the possible effects of these variations on corporate governance policies and practices
evaluate the effectiveness of a company’s corporate governance policies and practices
describe how ESG-related risk exposures and investment opportunities may be identified and evaluated
evaluate ESG risk exposures and investment opportunities related to a company
59
ESG issues are fundamentally about companies’ relationships with their stakeholders, which can include equity owners, creditors, employees, customers, suppliers, governments, and the members of the communities in which they operate.
relationships can be heavily influenced by a company’s ownership structure
60
Dispersed vs. Concentrated Ownership
A majority shareholder owns more than 50% of a company’s outstanding shares, while minority shareholders own less than 50% of the shares. Shareholders may be individuals or institutions.
Concentrated ownership, where a single majority shareholder can have the decision-making authority.
Another form of concentrated ownership occurs if no single individual has a majority ownership position, but a small group of shareholders work together to control a company. The small group of controlling shareholders may be members of the same family (usually Latinos)
61
In some cases, the controlling shareholder is a sovereign entity.
62
The small group of controlling shareholders can be made up of other companies that have established horizontal or vertical ownership arrangements. Companies with mutual interests, such as key customers and suppliers, can set up a horizontal ownership agreement with cross-holdings of shares between the companies. This helps facilitate strategic alliances and fosters long-term relationships.
Vertical ownership, also called pyramid ownership, involves a company with controlling interest in two or more holding companies.
63
Dispersed ownership, where a company’s shares are held by a diverse group of individual and institutional shareholders with no single shareholder having the ability to exercise unilateral control. This is the dominant form of ownership in English-speaking countries.
Uncommon for any single owner to hold more than 25% of a company’s shares.
64
The hybrid ownership model that is observed in some countries. For example, dispersed ownership is typical in Canada and Japan, but several large listed companies in these countries operate under concentrated ownership.
65
Dual-class (multiple-class) share structures create classes of shares with limited or no voting rights. For example, a founder may be able to retain complete control by owning 100% of a company’s voting shares even if these represent a minority of all outstanding shares.
Grants disproportionate voting rights to one class of shareholders and grants limited or no voting rights to other classes.
66
[Conflicts Within Different Ownership and Voting Structures]
1- Dispersed Ownership & Dispersed Voting Power
-- Characteristics: Shareholders are many and individually weak, with limited influence over management.
-- Key Issue: **Principal-Agent Problem** – Managers may act in their own interest due to lack of oversight.
-- How It Works: No dominant shareholder means poor monitoring, giving managers room to misuse resources.
2- Concentrated Ownership & Concentrated Voting Power
-- Characteristics: One or few shareholders control both ownership and votes.
-- Key Issue: **Principal-Principal Problem** – Controlling shareholders may exploit minority shareholders.
-- How It Works: Strong control improves managerial oversight but risks abuse of power against weaker shareholders.
3- Dispersed Ownership & Concentrated Voting Power
-- Characteristics: Control held through dual-class shares or pyramids, despite low ownership stake.
-- Key Issue: **Principal-Principal Problem** – Controlling party may take advantage without bearing proportional risk.
-- How It Works: High voting power with low financial exposure increases risk of self-dealing and poor governance.
4- Concentrated Ownership & Dispersed Voting Power
-- Characteristics: Legal limits on voting power despite large ownership (e.g., to protect national interests).
-- Key Issue: **Governance Limitation** – Not a direct conflict, but reduced effectiveness of large shareholders.
-- How It Works: Ownership influence is capped, weakening the ability to control or monitor management.
67
Types of Influential Shareholders
1. Banks:
Characteristics: Banks in Europe and Asia often hold equity stakes in companies they lend to.
Impact: Potential conflict of interest arises as banks may pressure companies to take on excessive debt or accept unfavorable terms to benefit the bank.
Key Concern: Misalignment of interests between the company’s management and the bank as both a lender and shareholder.
2. Families:
Characteristics: Family-owned businesses dominate in Latin America and are also significant in Europe and Asia. Interlocking directorates often exist.
Impact: Family ownership reduces the principal-agent problem, as managers (often family members) are aligned with shareholder interests.
Key Concerns:
Lack of transparency and accountability.
Challenges in hiring and retaining professional managers.
Potential neglect of minority shareholders' rights.
3. State-Owned Enterprises (SOEs):
- The company has significant strategic value to the sovereign government.
- The company’s capital requirements exceed the market’s funding capacity.
- The government wants to reduce the cost of a good or service (e.g., electricity).
Impact: Mixed ownership models (public and government ownership) can lead to reduced managerial oversight, especially when governments guarantee against bankruptcy.
Key Concerns: SOEs often prioritize social or policy objectives over shareholder value, creating potential inefficiencies.
4. Institutional Investors:
Characteristics: Include mutual funds, pension funds, hedge funds, and insurance companies. They often hold significant but non-controlling stakes.
Impact: Institutional investors are knowledgeable and hold managers accountable, promoting good corporate governance.
Key Strength: They foster transparency and responsible management practices.
5. Group Companies:
Characteristics: Vertical and horizontal ownership structures often create control disproportionate to ownership stakes.
Impact: Minority shareholders may find it difficult to exit due to less attractive shares.
Key Concern: Related-party transactions can harm minority shareholders without strong governance.
6. Private Equity Firms:
Characteristics: Private equity firms invest strategically, either in startups (venture capital) or mature companies (LBOs).
Impact: Willing to take majority positions and actively implement good corporate governance.
Key Strength: They align managerial practices with long-term shareholder value creation.
7. Foreign Investors:
Characteristics: Particularly influential in emerging markets; often expect companies to meet higher governance standards.
Impact: Cross-listing in foreign markets with strong governance standards benefits local minority shareholders.
Key Strength: Can raise the overall governance standard of the company.
8. Managers and Board of Directors:
Characteristics: Managers and directors with significant shareholdings are considered insiders.
Impact: Share ownership aligns their interests with shareholders but may lead to entrenchment.
Key Concern: Insiders with large ownership stakes may prioritize retaining power over the interests of other shareholders.
68
Effects of Ownership Structure on Corporate Governance
1- Director Independence: An independent director is a member of the board that is not employed or significantly remunerated by the company and is not a material shareholder of the company.
2- Board Structures : The more common structure is a one-tiered board, which can include both executive (internal - works at the company) and non-executive (independent/external - do not work at the company) directors. A two-tiered board has an executive board that is overseen by a supervisory board that often includes representatives of key stakeholder groups (e.g., unions, banks).
3- Special Voting Arrangements : Protect the interests of minority shareholders. For example, it may be necessary for independent directors to be approved by a majority of minority shareholders as well as a majority of all shareholders.
4- Corporate Governance Codes, Laws, and Listing Requirements : Companies are required to comply or explain why they have chosen not to adopt some corporate governance codes.
5- Stewardship Codes : Stewardship codes are intended to increase engagement of investors in corporate governance by encouraging investors to exercise their legal rights.
1- Enhanced scrutiny of management’s activities originated in jurisdictions where dispersed ownership (as opposed to concentrated ownership) is dominant.
2- Supervisory board’s functions may include reviewing annual reports, working with external auditors, and reviewing executive and managerial compensation.Some countries impose the structure, others lets choose.
3- Ensure that minority shareholders have greater influence over the composition of a company's board of directors.
4- While the codes are not law, they can be imposed.
5- A mandatory stewardship code would create a duty for institutional investors (such as asset management firms) to actively monitor their investments and publish a statement of compliance with the code.
69
Recommendation 2: Requiring independent directors to receive majority support from a company's entire base of shareholders as well as a separate majority among non-controlling shareholders.
What implementation :
A
two-tiered boards.
B
dual-class share structures.
C
special voting arrangements.
C) : Special voting arrangements may be used to ensure that minority shareholders have greater influence over the composition of a company's board of directors.
70
Investors should be familiar with a company’s disclosed corporate governance policies and engage in an ongoing dialogue with management about these issues. In some cases, shareholder activism may be required to achieve desired changes to policies.
can benefit investors in the form of better returns and higher dividends.
71
Board Policies and Practices
1- Board of Directors Structure : What matters for investors is that directors have the ability to make management accountable to shareholders. CEO duality exists when one individual simultaneously chairs a company’s board of directors and serves as its chief executive officer. This may cause investors to be concerned about the board’s ability to act independently of management
2- Board Independence : Minority of a company’s directors are independent, investors may adjust their valuations to reflect the greater risk of management acting against the interests of shareholders.
3- Board Committees : Potential conflicts of interest exist to the extent that executive (non-independent) directors impede the independence of board decisions on auditing, compensation, and managerial selection.
4- Board Skill and Experience : Board members should be sufficiently qualified to execute their responsibilities to shareholders (strong understanding of the ESG risks related to the company’s core operations).
5- Board Composition : Investors are not well served by a board that has become entrenched in its thinking and lacks the diversity to understand and appreciate alternative points of view (more diverse = better).
6- Other Considerations in Board Evaluation : Board of directors should evaluate its own effectiveness. Alternatively, an external review may be performed by a third party. A board review may be performed at regular intervals or on an “as needed” basis.
4- A long-term tenure (10+ years) for directors may be either advantageous for shareholders or detrimental to their interests (directors may become more closely aligned with management over the length of their tenure.).
72
Executive Remuneration
- How transparent is the company about its executive compensation packages?
- Which key performance indicators (KPIs) are used to evaluate executive performance?
- What long-term and short-term incentives do the compensation packages create?
- How well do these incentives align with the company’s overall strategy?
- Are these incentives consistent with maximizing shareholder value?
-How does executive compensation compare to average-worker pay?
A claw-back policy allows companies to regain previously paid compensation if mismanagement or misconduct is subsequently uncovered.
73
Say on pay provision
Companies may have a say on pay provision that allows shareholders to vote or at least provide feedback on
executive compensation.
74
Shareholder Voting Rights
Under a straight voting share structure, each share has the same voting rights. In a dual-class structure, certain classes of shares have enhanced voting rights.
75
Materiality and Investment Horizon
materiality is defined as whether an omission or misstatement would influence investment decisions. For ESG analysis, materiality is not as well-defined (can depend on nature of information).
Positive ESG data is emphasized, even when it has little to no impact on the company’s operations and financial performance. On the other hand, potentially significant negative ESG information may go unreported.
76
Certain ESG factors may be insignificant for short-term investment decisions but substantial for a long-term time horizon.
77
Relevant ESG-Related Factors
3 main approaches to identify the ESG factors for a company or industry:
1- Proprietary methods: Analysts collect data from regulatory filings, news reports, industry experts, trade organizations, company websites, and other publicly available sources.
2- Third-party vendors: Various ESG data providers produce individual company scores and/or rankings of companies (industries too)
3- Non-profit industry organizations and initiatives: Various industry organizations work to implement standardized frameworks for ESG reporting.
78
Equity analysts tend to consider ESG factors in the context of both downside risk and opportunities for growth. ESG factors are incorporated into the process of forecasting ratios as well as scenario/sensitivity analysis.
Fixed-income analysts generally only incorporate ESG factors to the extent that they relate to downside risk.
For example: Changes in environmental policies could leave a natural resource company with stranded assets that are no longer economically viable because they fail to meet the latest regulatory standards.
79
Fixed-income analysts may consider ESG factors when assessing a company’s creditworthiness (and/or credit spread)
80
What are Stranded assets ?
Stranded assets, are assets that are rendered obsolete due to legal or regulatory changes.
81
Because ESG good practice is becoming mandatory, companies must raise additional capital to fund environmental projects.
They can issue green bonds
82
What are Green Bonds ?
Green bonds are similar to conventional bonds except that their proceeds are used to fund projects that benefit the environment or climate.
Issuers incur additional costs related to monitoring and reporting to bondholders (verify that the project is indeed good for the environment).
83
Certain green eligibility criteria such as the Green Bond Principles, which were developed by a consortium of underwriters in 2014 and now overseen by the International Capital Market Association.
Adherence is voluntary, not mandatory
84
Currently the decision to designate a bond as green is made by the issuer, often in close consultation with the lead underwriter. Misrepresenting a project’s benefits when issuing green bonds is known as greenwashing.
85
What is Greenwashing ?
Misrepresenting a project’s benefits when issuing green bonds
86
Usually, green bonds are no different from conventional bonds in terms of credit ratings and bondholder recourse.
All types of green bonds (ABS,plain vanilla,etc)
87
Investors have shown a willingness to pay premiums for new green bond issues and accept narrower credit spreads relative to comparable ordinary bonds. However, investors tend to hold green bonds to maturity rather than trading them, so liquidity risk is a concern.
Some want to really help earth
88
The integration of ESG factors into the investment analysis process can be summarized :
Research-Level Activities
- ESG-integrated research note
- Centralized research dashboard
- ESG agenda at committee meetings
- Individual/collaborative/policy engagement
- Voting
- Company questionnaires
- Red-flag indicators
- Watch lists
- Internal ESG research
- SWOT analysis
- Materiality framework
89
Security-Level Activities: Equities
- Forecasted financials
- Forecasted financial ratios
- Valuation multiples
- Valuation model variables
- Security sensitivity/scenario analysis
90
Security-Level Activities: Fixed Income
- Internal credit assessment
- Forecasted financial ratios
- Relative ranking
- Relative value/spread analysis
- Duration analysis
- Security sensitivity/scenario analysis
91
Portfolio Level Activities
- Asset Allocation
-- Strategic asset allocation
-- Tactical asset allocation
- Scenario Analysis
-- Portfolio scenario analysis
- Portfolio Construction
-- ESG profile vs. benchmark
-- Portfolio weightings
- Risk Management
-- ESG and financial risk exposures and limits
-- Value-at-risk analysis
92
4.3 Cost of Capital : Advanced Topics
explain top-down and bottom-up factors that impact the cost of capital
compare methods used to estimate the cost of debt.
explain historical and forward-looking approaches to estimating an equity risk premium
compare methods used to estimate the required return on equity
estimate the cost of debt or required return on equity for a public company and a private company
evaluate a company’s capital structure and cost of capital relative to peers
93
Cost of Capital Factors
WACC ;
- Weights: Should be based on a target capital structure. However, a company's target weights may differ from its current capital structure and they may not be available to outside analysts.
- Tax rate: is the company's marginal tax rate, which must be estimated and will not necessarily match the company's effective or average tax rates.
- Costs: Estimates may differ and judgment is required to determine which, if any, estimate is "correct."
94
Costs :
- The pre-tax cost of debt (rd) : Estimated as the sum of the risk-free rate (rf) and a credit spread that investors require as additional compensation for holding risky debt.
- The cost of common equity (re): estimated using the the risk-free rate as a starting point, but then adding an equity risk premium (ERP) as compensation for equity market risk exposure adjusted for a beta measure that captures the risk of company's stock relative to the overall market.
- The cost of preferred equity (rp) : Typically higher than a company's pre-tax borrowing rate but less than the required return on its common equity because preferred shares have stated dividend rate and rank above common shares in terms of the priority of their claim to the company's assets.
(re>rp>rd)
95
Top-Down External Factors Influencing the Costs :
1- Capital Availability : A relative abundance of capital will allow corporate issuers to raise funds on more favorable terms (i.e., lower required returns). Companies seeking to raise capital in less developed markets tend to be more reliant on bank loans and funding from the unregulated shadow banking system.
2- Market Conditions : Higher inflation will be reflected in a higher risk-free rate, which will increase the costs of debt and equity capital. Credit spreads and ERPs are generally countercyclical — widening during recessions and narrowing as the economy expands.
3- Legal and Regulatory Considerations, Country Risk : Common law (USA) countries tend to have stronger, more mature legal systems with respect to the ability of investors to enforce their rights. This leads to more developed capital markets with more mature regulatory frameworks, which lowers risk premiums, credit spreads, and capital costs (not CIVIL LAW countries like FRANCE).
4- Tax Jurisdiction: Tax savings reduce the cost of debt on an after-tax basis. All else equal, a higher marginal tax rate will make debt a more attractive source of financing.
1- Capital Availability is influenced by liquid capital markets, strong legal protections for property risks and firm laws. --> Gives lowers the perception of risk = lower credit spreads and risk premiums.
2- Othe Exemples:
-- Predictable monetary policy = less volatility for rates and inflation = lower capital costs.
-- Greater exchange rate volatility increases currency risk and puts upward pressure on capital costs.
3- More significants in certains industries (e.g., banking, utilities).
96
Bottom-Up Company Specific Factors Influencing the Costs :
1- Revenue, Earnings and Cash Flow Volatility : Subscription-based = more predictable/stable earnings and cash flows = less risk = less costs of equity. Compared to pay-per-use revenue models that are more sensitive to macroeconomic conditions.
Greater exposure to ESG risks leads to higher capital costs due to expected losses from mitigation, boycotts, and litigation, while poor oversight and misaligned management interests further increase costs by eroding investor confidence.
2 - Asset Nature and Liquidity : Lower capital costs to the extent that their assets are tangible, fungible and liquid.
3- Financial Strength, Profitability, and Financial Leverage : Deteriorating profitability and poor cash flow generation will put upward pressure on the company-specific risk premium (investors look at indicators like debt-to-EBITDA)
4- Security Features:
-- Callability : Callable bonds give issuers the right to repurchase debt at a specified price (e.g., par value). Issuers exercise this option when interest rates fall to refinance at lower costs. Investors require higher yields for callable bonds as the embedded option benefits issuers.
-- Putability: Putable bonds allow investors to require the issuer to repurchase bonds at a specified price. Investors exercise this option when interest rates rise to reinvest at higher returns. Putable bonds offer lower yields compared to equivalent option-free or callable bonds.
-- Convertibility: Convertible bonds allow investors to exchange debt for equity when advantageous. Reduces the issuer's short-term cost of capital, but if exercised --> dilutes existing shareholders, increasing the long-term cost of equity. Conversion may force companies to issue new debt in high-interest environments.
-- Cumulative vs. Non-cumulative Preferred Shares Cumulative: Missed dividends must be paid before common shareholders receive dividends.
Non-cumulative: Missed dividends do not need to be repaid; issuers must only resume payments when common dividends are paid. Investors require less compensation for cumulative shares due to added security.
-- Share Class: Multi-class shares may allocate voting rights and cash flows disproportionately. One class may maintain majority control with a minority economic interest. Investors demand higher returns for disadvantaged share classes with limited voting rights or cash flow access.
1- Companies with higher customer concentration risk face greater sales risk because their revenues depend heavily on a small number of customers, , while higher operating leverage (fixed costs) and financial leverage (+ debt) increase earnings volatility.
2- Tangible assets --> good for collateral. Fungible = easily exchanged (cash). Can be converted to a unit of the same asset easily.
Liquid = can be quickly converted to cash.
4 - Cumulative vs Non : Both types of preferred shares are generally less costly than common shares, but investors will require even less compensation for holding cumulative preferred shares (compared to non-cumulative).
97
Traded Debt : Estimating a company's cost of debt is simplest for publicly-traded bonds. For straight bonds, the yield-to-maturity on the longest-maturity issue serves as a proxy for the pre-tax cost of new debt. If long-term debt is illiquid, short-term bond yields may better reflect borrowing costs. Market yields represent the cost of issuing debt with similar features.
If a market-based yield can not be inferred, estimate with factors:
1- Type of debt: Bank debt? Lease? Private placement?
2- Liquidity: How easily can the debt be converted to cash?
3- Credit rating: Has the debt been rated by an agency?
4- Currency: What is the currency of the debt's cash flows?
98
Non-Traded Debt : The number of companies with actively-traded public debt is small, and most debt issues are non-traded or highly illiquid, lacking reliable market-based yields for borrowing cost estimation. However, rated non-traded debt allows the cost of debt to be estimated using the yields of equally-rated bonds with similar maturities and features, a method called matrix pricing.
In the absence of a credit rating, one can be inferred by comparing the company to others with similar leverage ratios. Producing this synthetic credit rating requires the use of statistical models to classify bonds based on their similarities.
It is not necessarily appropriate to use the same rating for each of a company's debt issues. Certain issues can have higher or lower ratings depending on factors such as seniority and collateral.
99
What is Matrix Pricing ?
Non-traded debt issues may be rated; allowing the cost of debt to be estimated based on the yield of equally-rated bonds with similar maturities and features.
100
Bank Debt : Companies can lower their borrowing costs by structuring their bank loans to be fully or partially amortizing. Compared to non-amortizing loans, these are less risky for the lender because the principal is repaid in increments over the term of the loan rather than as a single bullet payment at maturity.
101
Leases : Many companies lease expensive fixed assets like airplanes or construction equipment, as capital leases function like amortizing loans. These leases are effectively secured loans, lowering financing costs compared to unsecured debt. To estimate the cost of this capital, analysts require inputs such as total lease payments, lease term, lessor's direct costs, asset fair value, residual value, and tax treatment of lease payments. Adjustments may be needed for tax implications.
102
International Considerations : Borrowing costs are influenced by the currency in which bond payments are made. For bonds in developing economies, the risk-free rate is adjusted by a country risk premium to account for economic conditions, political risk, exchange rate risk, and capital market uncertainty. Sovereign risk, the likelihood of government default, is a key component of country risk. Developed economy governments typically borrow at rates with no country risk premium, while yields on higher-risk sovereign bonds reveal the compensation required for country-specific risks. In developing markets, local government credit ratings serve as a benchmark, with adjustments made to estimate corporate borrowing costs.
103
Equity investors expect an equity risk premium (ERP) in excess of the risk-free rate for holding overall equity market (rather than one specific stock)
Two approaches that analysts commonly use to estimate the ERP are the historical (ex-post) approach and the forward-looking (ex-ante) approach.
104
Historical Approach
ERP is calculated as the difference between the return on a broad market index and the observed risk-free rate.
4 key decisions to estimate the equity risk premium :
1- Choosing an index that is representative of the overall equity market
2- Determining an appropriate time period to measure historical returns
3- Choosing the most appropriate measure to use for the mean return
4- Identifying the appropriate proxy for the risk-free rate
105
Equity Index Selection : When selecting a broad market equity index, it is important to ensure it has a reliable long-term return history and to consider its construction methodology (e.g., value-weighted) and rebalancing policies. The historical approach assumes returns are stationary and that average past returns predict future returns. Ideally, the index should represent typical past investor returns and reflect future expectations. Commonly used indexes include broad-based, value-weighted options with extensive historical records, such as the S&P 500.
106
Time Period :
A trade-off exists in selecting the time horizon:
1- Long Time Horizon:
-- Pros: Captures extensive market history.
-- Cons: Includes outdated market conditions and permanent changes (e.g., shifts in the equity risk premium), making it less relevant for estimating future expectations.
2- Short Time Horizon:
-- Pros: Focuses on recent and potentially more relevant data.
-- Cons: Susceptible to outliers, "noisy" data, and incomplete business cycles. It may also fail to reflect severe shocks, leading to an overstated equity risk premium (ERP) and understated volatility.
A balanced approach is needed to choose a time period that reflects both historical relevance and current market conditions.
107
Selection of the Mean Type :
A historical equity risk premium is calculated as the average difference between the equity market return (from an index) and the risk-free rate over a specific period. The average can be computed using either the arithmetic mean or the geometric mean:
1- Arithmetic Mean Return:
-- Definition: Simple average of periodic returns.
-- Advantages: Easy to calculate and includes all observations.
-- Disadvantages: Sensitive to extreme values and overestimates wealth accumulation over long periods by ignoring compounding.
-- Usage: Suitable for single-period forecast models, such as CAPM and multifactor models.
2- Geometric Mean Return:
-- Definition: The compound growth rate (or IRR) over the entire horizon.
-- Advantages: Considers compounding, less sensitive to outliers, and accurately reflects expected wealth accumulation at the end of the period.
-- Usage: Preferred for multi-period forecasts due to its realistic representation of long-term growth.
Both measures have their place in practice, with the choice depending on the forecasting context and time horizon.
108
Selection of the Risk-Free Rate Proxy :
To calculate an equity risk premium (ERP) using the historical approach, selecting an appropriate risk-free rate from the government yield curve is crucial. The choice between a short-term or long-term rate depends on the analyst's objectives:
1 - Short-Term Rate (e.g., 90-day Treasury bill):
-- Advantages: Represents a truly risk-free rate with no default or reinvestment risk, linking a current price to a terminal value.
-- Disadvantages: Does not match the indefinite duration of equity securities.
2- Long-Term Rate (e.g., 10-year Treasury bond):
-- Advantages: Better aligns with the duration of equity securities.
-- Disadvantages: Not entirely risk-free due to reliance on uncertain coupon reinvestment income.
In practice, both short-term and long-term government yields are commonly used as proxies for the risk-free rate, depending on the context of the analysis.
109
Limitations of the Historical Approach:
1- The equity risk premium (ERP) can change over time, including permanent shifts, making estimates based on long historical returns potentially unreliable as they may include outdated or irrelevant data.
2- Index returns and the ERP can be inflated due to survivorship bias, which arises when poorly performing companies are removed from an index and replaced with better-performing ones, skewing historical performance upward.
110
The Forward-Looking (ex-ante) Approach
Consistent with the view that required returns and premiums are entirely determined by expected future cash flows.
3 ways to estimate a forward-looking ERP rely on surveys, dividend discount models, and macroeconomic models.
111
Survey-Based Estimates : Surveying cross-section of experts about their capital market forecasts will produce a consensus return expectation from which an equity risk premium can be inferred. Surveys like this are regularly conducted and they generally produce higher estimates ERP estimates for developing markets compared to developed markets. However, one concern about survey-based estimates is that they are often overly sensitive to returns from the most recent periods.
112
Dividend Discount Model Estimates : With the Dividend Discount Model (DDM), specifically the Gordon Growth Model, find the equity risk premium (ERP) by subtracting the risk-free rate from the required return on equity.
The model is commonly used for forecasting and can be applied using either a top-down or bottom-up approach. Key assumptions include consistent growth rates for earnings, dividends, and stock prices. Adjustments are necessary for changes in variables like price-to-earnings ratios, dividend payout ratios, and stock repurchases, which can impact expectations for future earnings and dividends. For different stages of a company's life cycle, analysts may use varying growth rates: higher rates for initial growth, lower rates for transitional periods, and even lower rates for maturity.
113
Macroeconomic Modeling :
Macroeconomic models estimate the equity risk premium (ERP) using forecasts of economic variables. These models are particularly effective when equities form a significant portion of the economy. The Grinold-Kroner model calculates expected equity market returns as a combination of several components: forward dividend yield, repricing return (change in P/E ratio), share repurchases (reducing outstanding shares), expected inflation, and expected real GDP growth.
Key points:
- Share repurchases increase earnings per share by reducing the number of shares outstanding.
-- Nominal earnings growth per share combines expected inflation, real GDP growth, and the effect of share repurchases.
-- Expected capital gains per share are the sum of the repricing return and nominal EPS growth.
-- Expected inflation is derived from the difference between yields on nominal risk-free bonds and inflation-protected bonds.
114
Limitations of the Forward-Looking Approach:
1- Surveys
Sampling and response biases
Recency bias
Confirmation bias
2- Dividend Discount Models
Assumes constant relationships between price, earnings, and dividends
Adjustments are needed to account for changes in ratios
3- Macroeconomic Models
Modeling errors
Potential influence of behavioral biases
115
Three methods that analysts commonly use to calculate the company-specific cost of equity include dividend discount models (DDMs), the bond yield plus risk premium approach (also known as the build-up method), and risk-based models.
116
Dividend Discount Models
Gordon model --> It may not be realistic to assume that dividends will grow at a constant rate. In such circumstances, it is necessary to forecast expectations for both the dividends over a finite time horizon as well as the stock's price at the end of that period.
117
Bond Yield Plus Risk Premium (BYPRP) Approach
Estimates a company’s cost of equity by adding a risk premium to the yield on a long-term debt issue. This risk premium compensates investors for the additional risk of holding common stock over corporate bonds. It is typically calculated using the historical difference between the mean equity market return and the mean corporate bond index return.
Advantages:
- Provides a market-based assessment of
the company’s riskiness.
- Offers a straightforward starting point to
estimate the required return on equity.
Disadvantages:
- Estimating the risk premium is subjective and can vary significantly.
- Multiple debt yields may complicate the choice of a starting point if the company has more than one debt issue.
- Applicable only if the company has publicly traded debt.
118
Risk-Based Models
1- Capital Asset Pricing Model (CAPM) :
-- Inputs and Considerations: The choice of market index, analysis period, and proxy for the risk-free rate significantly influence the results. Formula --> re = rf + B(ERP)
(Market model [re = rf + B(rm-rf)] takes actual historical returns instead of E(rm))
2- Fama-French :
The expanded Fama-French model adds two more factors:
-- Profitability (RMW): Differentiates returns based on company profitability.
-- Investment (CMA): Differentiates returns based on conservative versus aggressive investment styles.
Formula --> ri = rf + B1(ERP) + B2(SMB) + B3(HML)
1 - Application to Private Companies:
To estimate the cost of equity for private firms, a comparable public company with similar business risk is used. The comparable firm’s beta is "unlevered" (adjusted for no debt) and then "relevered" to reflect the private firm’s capital structure. This adjusted beta is applied to estimate the private company’s cost of equit
2- Key Considerations:
-- Estimating factor betas requires a multiple regression model.
-- Factor beta estimates can vary significantly, and the market factor beta (ERP) may differ from its CAPM value due to the inclusion of additional factors.
-- Using a short-term risk-free rate in an upward-sloping interest rate environment may understate the risk-free rate, which can be addressed by selecting an appropriate time series.
-- The Fama-French model provides a more nuanced approach to estimating returns by accounting for multiple dimensions of risk, but it also involves more complexity and potential variability in inputs.
119
[CAPM Beta Rearrangement and Interpretation]
1- Capital Asset Pricing Model (CAPM) Formula
-- The CAPM estimates the required return on equity using the formula:
--- "re = rf + β(rm − rf)"
2- Rearranged Formula to Solve for Beta
-- When the required return on equity "re", the risk-free rate "rf", and the equity risk premium "(rm − rf)" are known, the CAPM can be rearranged to solve for beta:
--- "β = (re − rf) ÷ (rm − rf)"
3- Explanation of Variables
-- re: Required return on equity (WBM’s = 7.9%).
-- rf: Risk-free rate (given = 1.8%).
-- rm: Expected market return (implied via equity risk premium).
-- (rm − rf): Equity risk premium (given = 5.4%).
-- β: Sensitivity of the stock's return to market return fluctuations.
4- Application to the Example
-- WBM’s beta is calculated as:
--- "β = (7.9% − 1.8%) ÷ (5.4%) = 6.1% ÷ 5.4% = 1.1296"
120
Estimating the Cost of Equity for Private Companies
1- Adaptation of Risk-Factor Models: Risk-factor models, such as CAPM, cannot be directly applied as private companies do not have publicly traded stock.
2- Differences in Characteristics: Private companies tend to be smaller, owner-operated, earlier in their life cycles, and have more concentrated ownership compared to public companies.
3- Additional Risk Premiums: Required returns on equity for private companies typically include premiums for size, industry risk, and specific-company risk.
4- Illiquidity Risk: Illiquidity risk is not included as a premium in the discount rate but is instead reflected by applying a discount for lack of marketability directly to the company’s equity value.
Common Approaches:
1- Expanded CAPM: Includes additional premiums, such as size and company-specific risk, beyond the standard CAPM inputs.
2- Build-Up Approach: Combines the risk-free rate, equity risk premium, size premium, and a company-specific risk premium to estimate the required return.
-- Additional Risk Premiums:
Size Premium (SP) : Reflects the higher risk of smaller companies.
Company-Specific Premium (SCRP): Captures risks unique to the company that cannot be diversified.
121
Expanded CAPM : adds premiums for size and company-specific risk
re = rf + Bpeer(ERP) + SP + SCRP
However, an estimate of this premium based on historical data may be overstated due to the fact that smaller companies include once-larger companies that have experienced financial distress. A downward adjustment to this premium may be necessary.
Bpeer is the beta for a comparable publicly traded company (or a composite beta for a peer group of public companies) in the same industry as the subject private company. The size premium reflects the reality that private companies are generally smaller than public companies, which increases exposure to various risks.
122
Considerations that go into the development of the company-specific risk premium (SCRP) :
Qualitative factors --> Quantitative
Industry --> Financial leverage
Competitive position ---> Operational leverage
Customer/supplier concentration --> Earnings volatility
Geographic concentration --> Cash flow volatility
Corporate governance practices --> Earnings predictability
Asset nature and type ---> Pricing power
123
Build-Up Approach : When peer companies are unavailable or are not directly comparable, analysts can estimate a private company's cost of equity with various premia on top of the risk-free rate
re = rf +ERP + SP + IP + SCRP
where IP is an industry risk premium that is larger for companies operating in riskier industries.
124
1- Adding Equity Risk Premium: Begin by adding the equity risk premium to the risk-free rate to calculate the required return for an average-risk (β = 1) large-cap public company.
2- Adding Size Premium: Include a size premium to account for the higher risk associated with micro-cap public companies, resulting in the required return for an average-risk micro-cap public company.
3- Adding Company-Specific Premium: Add a company-specific risk premium to reflect unique risks, generating the final estimate for a private company's cost of equity.
125
International Considerations
Factor models such as the CAPM do not account for factors such as exchange rates and inflation, which are particularly important when analyzing companies that are based in emerging markets. 2 models therefore proposed as remplacements
1- Country Spread
2- Country Risk Rating Models
126
Country Spread and Country Risk Rating Models : The country spread model adjusts the equity risk premium for emerging markets by adding a country risk premium to account for additional risks such as political instability and expropriation. This adjustment depends on the company’s level of exposure to the local market. The country risk premium can be proxied by the sovereign yield spread, which is the difference between yields on bonds issued by developed and emerging market governments.
An alternative approach calculates the country risk premium by adjusting the sovereign yield spread using the ratio of the standard deviation of the local equity market to the standard deviation of the local bond market. This method requires reliable historical return data for both markets.
The country risk rating model categorizes countries by risk levels and uses yield differences between adjacent risk categories to estimate the incremental spreads for each category. These methods refine equity risk premium estimates by addressing country-specific risks.
ERPem = ERP for a developped market + (lambda * Country risk premium)
Lambda: represents the company's level of exposure to the local (i.e., emerging) market.
127
Extended CAPM : the global CAPM and the international CAPM.
1- The global CAPM (GCAPM) uses a global market index as its single factor and assumes no correlation between returns across countries. This results in low or negative correlations between returns in developed and emerging economies, often leading to lower returns for developed economies. To address this, a second variable for local market returns can be added if relevant data are available, improving the model's accuracy.
2- The international CAPM (ICAPM) estimates the returns on an emerging market stock by regressing it against the risk premiums for a global equity index and a wealth-weighted foreign currency index. The stock's sensitivity to the global market relative to the local market determines its global beta, while its currency beta reflects the sensitivity of the company's cash flows to imports, exports, and investments.
- the GCAPM and ICAPM methods are more appropriate for estimating the cost of equity for a company with global operations.
- The CRP method is more appropriate for companies with a relatively large share of their operations in emerging market countries.
128
The required return on equity is influenced by two key components:
1- The historical equity risk premium (ERP), which is often higher when calculated using a short-term risk-free rate due to the generally upward-sloping yield curve.
2- The current value of the risk-free rate, which serves as the base for the required return calculation.
In this scenario, the short-term interest rate (9%) is higher than the long-term interest rate (7%) due to an inverted yield curve. This means using the short-term rate as the risk-free rate inflates the required return on equity estimate. Additionally, the short-term rate reflects higher short-term inflation expectations (6%) compared to the long-term inflation forecast (4%), further overstating the long-term risk-free rate and required return.
Conclusion:
Using a short-term risk-free rate in this context biases the estimate of the long-term required return on equity upward because both the historical ERP and current short-term rate exaggerate future return expectations.
129
4.4 Corporate Restructuring
- explain types of corporate restructurings and issuers’ motivations for pursuing them
- explain the initial evaluation of a corporate restructuring
- demonstrate valuation methods for, and interpret valuations of, companies involved in corporate restructurings
- demonstrate how corporate restructurings affect an issuer’s EPS, net debt to EBITDA ratio, and weighted average cost of capital
- evaluate corporate investment actions, including equity investments, joint ventures, and acquisitions
- evaluate corporate divestment actions, including sales and spin offs
- evaluate cost and balance sheet restructurings
130
1- Start-Up:
Revenue Growth: Beginning.
Free Cash Flow: Negative.
Business Risk: High.
Debt in Capital Structure: Close to 0%.
2- Growth:
Revenue Growth: Rising.
Free Cash Flow: Improving.
Business Risk: Medium.
Debt in Capital Structure: 0–20%.
3- Maturity:
Revenue Growth: Slowing.
Free Cash Flow: Peak.
Business Risk: Low.
Debt in Capital Structure: 20%+.
4- Decline:
Revenue Growth: Negative.
Free Cash Flow: Declining.
Business Risk: Medium-High.
Debt in Capital Structure: 20%+.
131
Corporate Life Cycle and Actions
In theory, managers of mature-stage companies would better serve the interests of their shareholders by liquidating assets rather than transitioning into the decline stage.
Most large corporations consist of multiple business lines that operate in different competitive environments and may be at various stages of their life cycles. The primary benefit of this diversity is synergies, which include advantages such as cost efficiencies and access to in-house expertise, all achieved through a shared ownership structure.
Changes in a company's operations can be classified into three categories:
1- Investments: Actions aimed at increasing the size or scope of a company's operations. These can be internal, like expanding production capacity, or external, focusing on investments in other companies.
2- Divestments: Actions intended to improve financial performance by eliminating operations that are less profitable, riskier, or have lower growth potential.
3- Restructurings: Changes that do not alter the size or scope of operations but affect the company’s cost structure and/or financial structure.
132
Motivations for Corporate Structural Change
Type of Change --> (Motivations)
Investment actions --> ( - Realize synergies
- Increase growth potential
- Improve capabilities
- Access new resources
- Acquire an undervalued firm )
Divestment actions --> (- Improve operational focus
- Improve valuation metrics
- Meet liquidity needs
- Address regulatory requirements )
Restructuring actions ---> (- Improve return on capital metrics
- Avoid or respond to financial challenges)
133
Investments, divestments, and restructurings are more common during economic expansions due to the following reasons:
1- CEO Confidence: Increased confidence in the likelihood of success for these changes.
2- Lower Financing Costs: Reduced borrowing costs during periods of strong economic growth.
3- Equity-Financed Acquisitions: Opportunity to leverage inflated stock prices to fund acquisitions.
However, while changes are less likely to be undertaken during economic downturns, changes that are made at this stage of the business cycle typically generate higher returns for shareholders compared to those that are undertaken during expansions.
Some may be taken at any point in the cycle (industry shocks, regulatory changes, or the emergence of disruptive technology)
134
Types of Corporate Restructurings
Nine different types of corporate changes — three investment actions, two divestment actions, three restructuring actions, and leveraged buyouts, which combine aspects from all three categories.
135
Investment Actions: Equity Investments, Joint Ventures, and Acquisitions :
1- Equity Investments:
-- Involve purchasing a material but non-controlling stake in a company, typically 25–49% of shares and a proportionate share of board seats.
-- The acquirer and target remain independent but may use this as a step toward a full acquisition.
2- Joint Ventures (JVs):
-- Created when two or more companies establish a new, separate entity to pursue common goals.
-- Participants contribute resources and share profits or losses based on their ownership stakes.
-- Typically used for greater involvement and influence compared to an equity investment, often as a strategy to enter international markets with local partners.
3- Acquisitions:
-- Involve purchasing the majority or all of a target company's shares in exchange for cash and/or stock.
-- The acquirer gains control of the target’s assets and liabilities, and the target becomes a subsidiary.
-- Financial statements of the acquirer reflect consolidated totals from all subsidiaries.
136
Synergies arise when a combined entity creates more value than its individual parts. Companies pursue investments to reduce costs and/or increase revenues in ways that independent business units could not achieve.
1- Cost Synergies: Achieved by eliminating redundancies (e.g., consolidating corporate offices) or through vertical integration, such as acquiring key suppliers. However, negative synergies, or dis-synergies, can occur if duplicate costs are created.
2- Revenue Synergies: Generated through economies of scale, increased market share, or offering customers a one-stop shopping experience. Revenue dis-synergies may arise if, for example, an acquisition leads to cannibalization of sales.
137
Divestment Actions: Sales and Spin-Offs: Acquisitions help companies grow and achieve economies of scale, but those that make a series of acquisitions over time risk becoming unfocused conglomerates with loosely related subsidiaries. This can result in a conglomerate discount, where the company's value is less than the sum of its parts. Divesting certain business lines can create more shareholder value by allowing these units to operate independently or be sold to better-suited owners, while enabling management to focus on core competencies.
The two main forms of divestments are:
1- Sales (Divestitures):
-- Involve transferring a business segment, line, or group of assets to an acquirer in exchange for cash.
-- The seller relinquishes control and no longer bears liabilities related to the divested assets.
2- Spin-offs:
-- Turn one of the parent company's segments into a separate, independent company.
-- Shareholders of the parent company receive shares in the new entity, which issues its own securities and files separate financial reports.
138
A conglomerate deciding between a sale or a spin-off must evaluate several factors:
1- Sale:
-- Preferred when addressing liquidity concerns, as it generates immediate cash proceeds.
-- Faster to execute since it does not require partitioning assets, employees, or functions.
2- Spin-off:
-- Better suited when the parent company's liquidity needs are not urgent.
-- More attractive if the new entity’s shares are expected to appreciate significantly in value after becoming independent.
139
Restructuring Actions: Cost Restructuring, Balance Sheet Restructuring, and Reorganization :
The motivations for issuer-specific restructuring actions can be categorized as:
1- Opportunistic Improvements:
-- These involve changes to the business model, cost structure, or financing to improve the company's return on invested capital.
-- An example is adopting an asset-light franchise model with lean operations, generating royalties from licensing intellectual property.
2- Forced Improvements:
-- Undertaken when a company is unable to generate profits that meet or exceed investor return expectations.
140
The three types of restructuring actions are cost restructuring, balance sheet restructuring, and reorganization.
1- Cost Restructuring:
-- Typically undertaken after underperformance or to achieve synergies post-acquisition.
-- Aims to improve operational efficiency and increase profit margins.
-- Common techniques include outsourcing and offshoring.
Outsourcing:
-- Involves using third parties to perform internal functions like IT, legal, or finance.
-- Third parties can deliver services at lower costs due to economies of scale, freeing up resources tied to expensive assets like offices.
-- Requires ongoing oversight and management of outsourcing relationships.
Offshoring:
-- Relocates operations to another country while keeping them within the company, often through establishing foreign subsidiaries.
-- Motivated by cost savings, such as lower labor costs, and achieving economies of scale.
-- Can be used as an alternative to outsourcing or combined by outsourcing to foreign partners.
141
2- Balance Sheet Restructuring involves changes to a company’s asset composition and/or capital structure. Common actions include sale leasebacks and dividend recapitalizations.
1- Sale Leaseback:
-- A company sells an asset it currently uses, such as an office building, and enters into a long-term lease to continue using it.
-- Operations remain unaffected, but ownership risks like maintenance and obsolescence are transferred to the buyer.
-- The company receives a large upfront cash payment but incurs periodic lease payments that are typically higher than the annual depreciation and amortization costs when the asset was owned.
2- Dividend Recapitalization:
-- Involves taking on additional debt to finance a special dividend payment or share repurchase.
-- Borrowing in a low-interest rate environment can lower the company’s weighted average cost of capital by increasing the share of debt in its capital structure.
-- However, it raises financial leverage, increasing fixed financing costs. Companies with stable revenues and cash flows are best suited for this strategy.
142
3- A reorganization is a court-supervised restructuring process for insolvent companies, where creditors negotiate competing claims. If creditors believe the company can return to profitability, they may agree to convert debt into equity positions. Once the court approves the agreement, the company can continue operating with a reduced debt burden. This contrasts with a liquidation, where the company’s assets are sold for cash, and no reorganized entity emerges.
143
Leveraged Buyouts: A leveraged buyout (LBO) is a largely debt-financed acquisition that combines elements of investments, divestments, and restructurings. LBOs are typically conducted by private equity firms, also known as buyout funds, rather than corporate acquirers.
The typical target is a mature, publicly listed company with stable cash flows. The buyout fund takes the company private, introduces a more leveraged capital structure, and often installs new management to implement operational changes. After restructuring, an exit strategy may involve returning the company to public markets through an initial public offering.
The success of an LBO depends on factors such as the purchase price, debt level, free cash flows generated during ownership, and the sale price upon exit.
144
The process of evaluating corporate investments, divestments, and restructurings involves three steps.
In the following exemples, the action is an acquisition of a target company.
145
Step 1: Initial Evaluation involves answering key questions to assess a company's changes:
1- What is happening?
2- Why is it happening?
3- Is it material?
4- When is it happening?
Answers to "what" and "why" are typically found in press releases, public statements, and regulatory filings. However, it is crucial to critically evaluate management’s claims about their motivations and the likelihood of success.
The most critical question is about materiality, which can be assessed based on the size of the change, its strategic fit with the company, or its potential impact on the share price.
146
The size of an action can be evaluated in several ways:
1- For restructurings, size is measured as the value of anticipated cost savings or revenue increases relative to the company’s annual revenue or operating expenses.
2- For acquisitions, materiality can be assessed by comparing the purchase price to the acquirer’s enterprise value. A 10 percent threshold is often used, though most acquisitions fall below this and are considered immaterial by this standard.
Fit may provide a better indicator of materiality. Even small acquisitions can signify major shifts in strategy, such as when a mature company acquires a small, unrelated private firm to explore new growth opportunities. This might indicate a need to redefine the company’s business strategy.
Share price changes following an announcement are often viewed as a market-based measure of magnitude. However, empirical evidence suggests short-term price movements do not reliably correlate with a company’s long-term ability to generate excess returns.
147
The final aspect of the initial evaluation is timing. While market prices react immediately to major announcements, the actual transactions can take months or years to complete. Acquirers often require even more time to fully integrate the target company, meaning the deal's impact may not be fully reflected in financial statements for several years.
148
Step 2 : Preliminary Valuation
If a proposed acquisition is deemed to be material, the next step in the process is to conduct an independent assessment of its expected impact. Three popular valuation techniques are comparable company analysis, comparable transaction analysis, and premium paid analysis.
1. Comparable Company Analysis assesses the fair value of a target company by comparing its metrics to those of similar companies.
1- Peer Selection:
-- Comparable firms are chosen based on factors like size, capital structure, revenue growth, and return on invested capital.
-- Ideally, peers operate in the same industry, though related sectors may also be included.
2- Valuation Multiples:
-- Uses enterprise multiples (preferred) or equity multiples.
-- Common enterprise multiples include EV/Sales, EV/EBITDA, and EV/Free Cash Flow.
-- Sector-specific multiples, such as EV/Proven Reserves, may also be applied.
3- Process:
-- Mean multiples for the peer group are applied to the target company’s relevant metric.
-- Multiple metrics may be weighted equally or based on their perceived importance. Analytical judgment is used to decide metrics and weights.
4- Limitations on Takeover Valuation:
-- This method estimates the fair value of the target company but does not include a takeover premium, which must be estimated separately.
-- It is typically used for spin-off transactions rather than takeovers.
149
(1). Comparable Company Analysis :
Advantages:
1- Assumes similar companies should have similar valuation multiples, providing a reasonable approximation of fair value.
2- Relies on readily available data.
3- Values are based on market-determined prices rather than assumptions, unlike discounted cash flow methods.
Disadvantages:
1- Finding directly comparable peers may be difficult, especially for industry leaders.
2- Valuations are sensitive to market mispricing.
3- Does not estimate a takeover premium, requiring additional analysis for a fair takeover price.
150
2. Comparable Transaction Analysis estimates the fair value of a target company based on valuation multiples derived from prices paid in recently completed mergers and acquisitions of comparable companies, rather than current market prices or trading multiples. Metrics such as acquisition price to earnings, sales, or book value are commonly used. This approach inherently reflects a takeover premium embedded in actual market transactions.
This method provides a realistic valuation by incorporating real transaction data but requires careful adjustments to account for changing conditions and potential distortions in the data.
Advantages:
1- Takeover values are based on actual market transactions rather than assumptions, as in discounted cash flow models.
2- The takeover premium is directly embedded in the valuation from comparable transactions, eliminating the need for separate estimation.
Disadvantages:
1- The market for corporate control is relatively illiquid, so few comparable transactions may exist. Adjustments may be needed for industry differences.
2- Historical multiples reflect macroeconomic and industry conditions at the time of the transaction. Adjustments may be required for changes in conditions or to exclude older transactions (e.g., those older than 10 years).
3- Comparable transactions may reflect over- or underestimation of value, such as when competitive bidding processes lead to acquirers overpaying for targets.
151
3. Premium Paid Analysis calculates the takeover premium, or control premium, that an acquirer must pay above the target company's current stock price to entice shareholders to sell. The takeover premium is expressed as a percentage of the current stock price.
For historical transactions, the stock price used should exclude any influence from speculation or media reports about the deal. Typically, this is the price one week before the formal announcement, though a longer timeframe may be necessary if there were persistent rumors.
In practice, takeover premiums average around 30% above the pre-announcement stock price and typically fall within a range of 20–40%.
Takeover premium = (Deal Price - Stock Price) / Stock Price
152
Step 3: Modeling and Valuation
After estimating the target company's fair value, the next step in the evaluation process is to produce a set of pro forma financial statements for the combined entity.
When combining the financial totals of the acquirer and the target, the following adjustments must be made:
1- Revenues:
-- Add revenue synergies.
-- Subtract any revenue dis-synergies.
2- Operating Expenses:
-- Subtract cost synergies.
-- Add any cost dis-synergies.
3- Amortization:
-- Add amortization of acquired intangible assets.
4- Interest Expense:
-- Add interest on any debt issued to fund the acquisition.
-- Exclude the target’s pre-existing interest expense.
5- Income Taxes:
-- Use a weighted average of the two companies’ tax rates.
6- Shares Outstanding:
-- Start with the acquirer’s current total.
-- Add any new shares issued as part of the acquisition.
153
Acquirer and a target to form a combined company:
1- Acquirer:
-- Financing: Includes borrowing, interest, and share issuance to fund the acquisition.
-- Accounting and Tax: Factors such as goodwill, fair value adjustments, and tax effects must be incorporated.
2- Target:
-- Synergies or Dis-Synergies: Adjust for revenue synergies or dis-synergies and cost synergies or dis-synergies.
-- Divestitures/Asset Sales: Includes voluntary divestitures or those required by regulators.
These adjustments ensure the combined company reflects the financial, operational, and regulatory implications of the merger.
154
Pro Forma Weighted Average Cost of Capital (WACC) is used in the discounted cash flow model to estimate the value of a target company by discounting its free cash flows to the firm. However, adjustments to the acquirer’s WACC must account for changes in capital structure due to the acquisition.
1- Impact of Financing on WACC:
-- A 100% debt-financed acquisition increases the acquirer’s financial leverage.
-- Higher leverage typically reduces WACC because debt is generally less expensive than equity.
-- However, this reduction may be offset if higher leverage increases the cost of debt, especially if the acquirer’s credit rating is downgraded (e.g., from investment grade to speculative grade).
2- Key Factors Affecting Cost of Debt:
-- Metrics like debt-to-equity ratio, interest coverage, and overall creditworthiness influence lenders' required rates of return.
-- A deteriorated financial position post-acquisition may lead to higher borrowing costs, negating the benefits of cheaper debt.
Adjusting WACC to reflect the financing structure of the acquisition ensures a more accurate valuation of the combined company.
155
Key factors and metrics that lenders consider when determining their required rates of return :
1- Profitability:
-- EBIT/Sales
-- EBITDA/Sales
2- Volatility:
-- Standard deviation of revenues
-- Standard deviation of EBITDA
3- Leverage:
-- Debt/EBITDA
4- Collateral:
-- Asset liquidity
5- Interest Rates:
-- Benchmark reference rates
-- Credit spreads
