Guiding Seminar VI Flashcards
Is the US public corporation in trouble?
• The number of public firms has decreased significantly in the past 20 years (low nr of new firms, high nr of delists)
• Why delist?
o Bankruptcy
o Firm gets acquired (main reason)
o Voluntarily delisting
• Public firms are on average becoming much older than they were before (potentially bad because less innovation etc.)
• They also have become much larger in terms of market cap and concentration within industries (potentially bad because less competition, barriers to entry)
• Firms have more Intangible assets because of Investing in R and D, but the overall level of investment has decreased
• Firms hold more cash to fund those R and D expenditures
• As a result, balance sheets less informative because R and D does not appear on them
• In terms of profitability large firms are now more profitable than ever, but all the other firms perform poorly on average (higher fraction of firms with negative profit), so there is a large profit concentration
• R and D hard to use as collateral so firms borrow much less on average, the average firm holds more cash than debt
• Payout ratio is at all-time high because of the previously mentioned facts that firms are older, therefore, have less good investment opportunities
• Share repurchases are also very frequent nowadays
• Implications:
o Consolidation theory: less-efficient firms are acquired by more efficient firms, which would explain the concentration. However, this only holds for public companies
o Little willingness for companies to go public
Do not want to meet the disclosure requirements
Easier to raise funds privately
Markets are dominated by institutional investors who pay little attention to small firms
Fintech and banking: What do we know?
• What promotes adaption of fintech?
o Investments in fintech companies are higher in more financially-developed countries
o Investments in fintech companies are higher in countries with less competitive (more concentrated) banking systems
o Investments in fintech companies are higher in countries with higher lending interest rates and lower deposit interest
• Goal of fintech is to basically reduce costs
• Examples of fintech
o P2P lending
o Shadow banks
o Crypto
o HFT platforms, e-trading, robo advising
o More precise insurance products
• Q1: How do we modify financial intermediation theories to accommodate banks, shadow banks and non-intermediated solutions?
o P2P platforms have little incentives to monitor and screen loan applications so there are trust concerns. You could change the fee structure (collecting fees from repayment, not origination)
o Still P2P has much lower operating costs
• Q2: Impact of fintech on credit, deposits and capital raising: will P2P lending replace bank lending?
o There is a trend of loan migration from banks to P2P. This effect of migration is more pronounced in countries where fewer people use banking services.
o Empirically, banks improve profitability, asset quality and stability when facing competition. Hence, P2P might actually not be the end for bank lending.
• Q3: On payments, clearing and settlement, what will be the role of cryptocurrencies vis-a-via fiat money? How will this affect central banks?
o Digital wallets: combine various services, payments, keys, tickets, IDs. Their role is even more important in developing countries, where people sometimes have limited access to financing
o Central banks might introduce their own digital currencies (digital euro) to lower costs, control commercial banks more efficiently, initiate monetary policies such as NIRP more efficiently
• Q4: How will Blockchain-technology-assisted smart contracts transform the financial market, including investment management and insurance?
o Further expand the space for feasible contracts. It enable the agents who have no trust in each other to collaborate without having to go through a central authority. Moreover, Blockchain improves efficiency through lowering the contracting costs, intermediary costs, verification costs and other types of costs. Also has applications that increase accuracy and offer more tailored experience.
o Banks will adapt and become the providers of the smart contracts. The adaption is likely because banks are more trusted with things such as data the smart contract is gathering.
The COVID-19 pandemic crisis and corporate finance
• Editorial review that summarizes the freshest findings regarding the impact of the coronavirus pandemic on firm financing, ability to continue raising the financing and the reactions of stock markets.
• Financing of corporations:
o Banks are the first line of defense. The data suggests that the firms drew funds from preexisting lines of credit at an unprecedented scale, with large banks providing most of the required funding
o Investment grade firms managed to maintain access to public capital markets and issued both bonds and equity
o Firms chose to issue bonds with longer maturities during the crisis while equity issues slowed
• Debt better be raised in the short term because the long-term debt will lead to debt overhang, when the entity cannot take any more debt to finance the future project, and this in turn will slow down the recovery
• Firm characteristics and stock prices:
o Firms in the United States with high environmental and social (ES) scores suffered lower stock price declines compared to other firms, attributed to customer and investor loyalty
Feverish stock price reactions to COVID-19
• Covid-19 - truly exogenous shock:
o Can investigate causality of trade and financial policies, as well as their effectiveness
• Trade policy
o Incubation and outbreak periods: Exposure to china and international exposure in general leads to lower returns
o Fever period: as china starts to reopen, those exposed to china experience increased stock returns
• Financial policy:
o Corporate leverage: in Fever period higher leverage leads to lower returns
o Cash holdings: due to arising uncertainty, higher cash holdings result in higher returns in both outbreak and fever periods
o Cash holdings are especially important to those companies with high leverage
o High book-to-market firms are penalized worse for having high leverage
o These findings hold for most industries
• Manager and analyst communications:
o Firms that do not discuss covid on their conference calls have higher returns
o Calls covering the coronavirus are on average more negative (in terms of stock returns) than calls not covering it; In addition, negativity is higher in firms with stronger international orientation (Outbreak phase) and higher leverage (Fever)
Equity valuation using multiples
- Multiples are a simple valuation technique that is used widely in practice but there is very little empirical research on it. This study documents the extent to which different value drivers serve as a summary statistic for the stream of expected payoffs.
- Forward earnings perform the best, and performance improves if the forecast horizon lengthens (1-year to 2-year to 3-year out EPS forecasts) and if future earnings forecasted are aggregated
- Intrinsic value measures, based on current equity value and present value of future income, perform considerably worse than forward earnings. They do utilize more information but there is measurement error associated with extra variables
- Among drivers derived from historical data, sales performs the worst, earnings performs better than book value
- Forward earnings contain considerably more value-relevant information than historical data, and they should be used as long as earnings forecasts are available
- Performance improves when multiples are computed using the harmonic mean. This is used for rates, gives equal weight to each data point
- Performance improves when multiples are computed using the harmonic mean. This is used for rates, gives equal weight to each data point
Capital structure
• This paper attempts to explain a mix of financing sources used by corporations to finance real investment and provides a review of the tradeoff, pecking order and free cash flow theories of capital structure.
• M and M: in reality the financing choice does matter because there are taxes (trade-off theory), difference in information (pecking order theory), agency costs existing (FCF theory).
• Trade-off theory
o The firm will borrow up to the point where the marginal value of tax shields on the additional debt is just offsetted by the increase in the costs of possible distress. According to the theory, a value-maximizing firm should never miss the chance of utilizing “interest tax shield” when the cost of the financial distress is low. However, the most profitable companies tend to borrow the least. The trade-off theory does not explain the correlation between high profitability and low debt ratios.
• Pecking order theory
o The firms prefer internal financing and debt over the equity issue, due to information asymmetry between managers and investors (If firms issue stock, investors believe that managers have some private information about poor future prospects, that the equity today is overvalued). As a result, the stock price drops after the announcement of an equity issue.
• FCF theory
o Built around the idea of agency costs i.e. conflict between managers and stockholders, when managers tend to act in their own best interest. For example, empire building (managers want to run a large business), private benefits of control, “pet projects”, managerial overconfidence, entrenching investments
o FCF is not really a theory predicting how managers will choose capital structures, but a theory about the consequences of high debt ratios. FCF goes together with the trade-off theory and explains why managers do not fully exploit the tax advantages of borrowing.
• Debt and equity holder conflicts
o If managers act in the interests of stockholders, when facing the risk of default, they will tend to transfer risk from creditors to debtors (Overinvestment, underinvestment, playing for time, cashing out).
o Debtors are aware of the conflicts and try to avoid them by writing contracts (debt covenants) properly. The covenants restrict additional borrowing, limit dividend payouts and other distributions to stockholders, and ensure that debt is immediately due and payable if other covenants are seriously violated.
Corporate payout policy (sections 3, 8–10, 13)
• The paper describes dividend payout theories, reasons for paying high/low dividends, the phenomenon of signaling as well as the advantages of stock repurchases.
• Dividend payout: life cycle theory
o Young companies have good investment opportunities, therefore, need cash, therefore, payout ratio low.
o The opposite for mature companies
• Factors stimulating increase in dividend payout:
o investors pressure managers to accelerate cash payouts (avoid wasteful investment & managers’ personal benefits i.e. agency costs)
o managers have incentives to build a reputation for treating investors fairly in their payout decisions to be able to sell future equity at higher prices
o firms generating large amounts of FCF are “sitting ducks” for takeovers by activist investors. If investor demand for dividends are not fulfilled, the company valuation decreases and could be easier to be overtaken.
• Factors retaining payouts:
o agency problems – managers make decision to keep cash
o Servicing different tax clienteles: some investors face high tax rate on dividends, hence they prefer deferred payouts
• Signaling using dividends
o Dividend changes are not useful in predicting future earnings changes. Changes in dividends tell us mostly about what has happened, not what will happen.
o Firms that increase dividends are less likely to experience a decline in future earnings than firms that do not increase them. This could be explained by the fact that managers are reluctant to increase dividends when the chances are good that they will later be forced to reverse that decision.
o Dividend reductions are typically associated with large share price declines, but it does not indicate that managers deliberately use dividend cuts to signal bad news to investors.
• Reasons for high dividends:
o Lower agency costs
o Mature company
o Signaling theory
o Bird in hand theory
o Clientele effect
o Trading costs (costly to replicate dividend payout)
• Reasons for low dividends:
o Costs of financial distress
o Good growth prospects
o Personal taxes of shareholders
o Clientele effects
• Advantages of share buyback
o Financial flexibility (no yearly commitment)
o Helps correct stock market valuation (if undervalued)
o Remove low valuation stockholders (as a measure of caution against takeovers)
o Allocation of voting rights (increase managers percentage ownership of voting rights)
o Increase reported EPS
o Provide liquidity to investors who want to exit
